What is Leverage Ratio?
Leverage ratio is a ration used to ascertain the financial leverage of any company to get an idea about the company’s methods of financing or to know its ability to meet financial obligations. It is also a ration used to calculate company’s mixture of operating costs showing how changes will affect operating income. In simple terms, leverage ratio helps to know the health of any company. The more debt a company has, the riskier its stocks would be. The most common leverage ratios are debt-to-equity ratio and debt ratio.
What is Debt Ratio and Debt-to-Equity Ratio and how do we calculate them?
A debt ratio is a company’s total debt divided by its total assets
Debt Ratio = Total Debt / Total Assets
Let’s take an example: if ABC Company had INR 1,000 crore of debts in its balance sheet and INR 1,500 crore of assets, then the debt ratio of this ABC Company would be like this:
Debt Ratio = 100000000000 / 150000000000 = 0.67 or 67%
This implies that for every rupee of ABC Company’s assets, the company had a debt of Rs. 0.67. If the ratio of any particular company is more than 1.0, it shows that company has more debts than its assets.
Similarly, Debt-to-Equity Ratio = Total Debt / Total Equity
Which implies that for every Rupee of Company’s shares owned by shareholders, company owes a particular section to them.
Significance of Leverage Ratio
Knowing leverage ratio is crucial since it measures how leveraged a company is and its degree of leverage is often a measure of risk. Before investing in any company, it gives the investor an idea of where the company is coming from and where it is standing at the moment. Investors and lenders often prefer a low leverage ratio since the lender’s interest are better protected in the event of a business going down.