What is a Leverage Ratio?

A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement.  

The most common leverage ratios are: 

• debt to equity, and 
• debt to capital.

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How Does a Leverage Ratio Work? 

Most businesses depend on funds from financial institutions and investors to expand their operations. However, it is important to note that too much debt can be harmful. A controlled debt helps a company to generate earnings. Also, for a firm to make profits, its returns on capital must be more than the interest rate it pays on debts and loans. Also, uncontrolled debt can reduce the company's credit rating. 

On the other hand, a company with few debts may also be questionable. Note that some investors may see a lack of borrowing as a sign that the operating mechanism is tight. So, the leverage ratio ensures that there is a perfect balance between capital structure and cost of capital. 

A company can also make use of leverage ratios to measure a business's mix of operating expenses. By doing so, it is able to know how changes in output affect operating income. Operating costs are of two types: variable and fixed costs. However, the mix is likely to differ depending on the industry and company.

Related Topics

• Trend Analysis of Financial Statements
• Common-Size Analysis (Vertical Analysis) of Financial Statements
• Common-Size Financial Statement
• Net Dollar Retention
• Horizontal Analysis
• Per Share Basis
• Profitability Ratios
• Gross Margin Ratio
• Profit Margin
• After Tax Profit Margin
• Return on Assets
• Total Shareholder Return
• Cash on Cash Return
• Earnings Per Share
• Diluted Earnings Per Share
• Asset Turnover Ratio
• Berry Ratio
• Break-Even Analysis
• Liquidity Ratio
• Current ratio  (Working Capital Ratio)
• Working Ratio
• Quick Ratio
• Quick Assets
• Days Sales Outstanding
• Cash Ratio (Operating Cash Flow Ratio)
• Receivables turnover ratio (often converted to average collection period)
• Accounts Payable Turnover Ratio
• Inventory turnover ratio (often converted to average sale period)
• Solvency (Coverage Ratios)
• Leverage Ratio (Debt Ratio)
• Asset Coverage Ratio
• Debt to Equity
• Debt to Income Ratio
• Debt Coverage Ratio
• Times Interest Earned
• Market Capitalization
• Price to Equity Ratio
• Book-To-Market Ratio
• Price to Earnings Ratio
• Price to Earnings Growth (PEG) Ratio
• Price to Earnings Growth Payback Ratio
• CAPE Ratio
• Price to Cash Flow Ratio
• Capital Maintenance
• Book to Bill Ratio
• Asset Turnover Ratio
• Plowback Ratio 
• Days Inventory Outstanding
• Days Payable Outstanding
• Days Sales Outstanding
• Non-financial Performance Measures: The Balance Scorecard