## Leverage Ratios

Leverage ratios are financial metrics used to measure a company’s ability to meet its financial obligations. They provide an indication of the company’s long-term solvency and highlight the extent to which its operations are funded by debt as opposed to equity.

The following are some of the most commonly used leverage ratios:

**Debt Ratio:**This is the proportion of a company’s assets that is financed by debt. It is calculated as total debt divided by total assets. A higher ratio suggests higher financial risk because a larger proportion of the company’s assets are financed by debt.**Debt to Equity Ratio (D/E):**This ratio compares a company’s total debt to its shareholders’ equity. It’s calculated as total debt divided by total equity. A higher D/E ratio indicates that the company has been aggressive in financing its growth with debt, which can result in volatile earnings due to the additional interest expense.**Equity Ratio:**This ratio, a complement to the debt ratio, measures the proportion of a company’s assets financed by shareholders’ equity. It is calculated as total equity divided by total assets.**Times Interest Earned Ratio (TIE):**Also known as the interest coverage ratio, it measures how many times a company can cover its interest charges on a pre-tax basis. It’s calculated as earnings before interest and taxes (EBIT) divided by interest expenses. A lower ratio can be a red flag for potential creditors as it indicates the firm might have difficulty paying its debt obligations.**Debt Service Coverage Ratio (DSCR):**This ratio measures a company’s ability to service its current debts by comparing its net operating income with its total debt service obligations. A DSCR of less than 1 means the company doesn’t generate enough cash flow to cover its debt obligations.

These leverage ratios are used by investors, creditors, and other market participants to assess a company’s financial health and risk profile. However, what is considered a “healthy” or “normal” ratio can vary widely between industries, so it’s important to compare a company’s ratios with those of other companies in the same industry.

## Example of Leverage Ratios

Let’s consider an example to understand how leverage ratios work. Imagine we have a hypothetical Company X with the following financials:

- Total Assets: $1,000,000
- Total Debt (liabilities): $600,000
- Total Equity: $400,000
- Earnings Before Interest and Taxes (EBIT): $150,000
- Interest Expense: $50,000

Using these figures, we can calculate the following leverage ratios:

**Debt Ratio:**

Total Debt / Total Assets = $600,000 / $1,000,000 = 0.6 or 60%.

This means that 60% of Company X’s assets are financed by debt.**Debt to Equity Ratio (D/E):**

Total Debt / Total Equity = $600,000 / $400,000 = 1.5.

For every dollar in equity, Company X has $1.5 in debt.**Equity Ratio:**

Total Equity / Total Assets = $400,000 / $1,000,000 = 0.4 or 40%.

This means that 40% of Company X’s assets are financed by equity.**Times Interest Earned Ratio (TIE):**

EBIT / Interest Expense = $150,000 / $50,000 = 3.

This indicates that Company X’s operating earnings are 3 times its interest expenses.

By looking at these ratios, an investor, creditor, or analyst can gain a better understanding of Company X’s financial leverage and its ability to meet its financial obligations. For example, a debt ratio of 60% might be concerning if most companies in the same industry have a debt ratio of 30%. Similarly, a times interest earned ratio of 3 would be seen as more favorable compared to a ratio of 1.5.

However, these ratios should not be considered in isolation, but should be used along with other financial ratios and information to build a complete picture of a company’s financial health.