- Last Updated: August 5, 2020

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## Define Leverage Ratios In Simple Terms

Leverage ratios are financial ratios that specify the level of debt incurred by a business relative to other accounting heads on its balance sheet.

For example, the debt-to-equity ratio is a leverage ratio that displays the total amount of debt for a business in relation to its stockholder equity.

Generally, a company’s debt is measured against five accounts: total assets, total equity, total operating expenses, and total income.

## Leverage Ratios Example

The five most commonly used leverage ratios are:

## Leverage Ratios Explanation

Leverage ratios are generally assigned scores starting from 0.1.

A leverage ratio of 1 means the company has equal amounts of debt and the other, comparable metric being measured.

A leverage ratio greater than 1 may not be a good sign because it means that the company has high levels of debt and not enough assets or earnings to make payments for that debt.

## Leverage Ratios Purposes

Primarily, leverage ratios are used for two purposes:

- They are indicators of a company’s ability to meet its short-term and long-term debt obligations. A leverage ratio greater than 1 indicates that the company is operating with significant amounts of debt and may not be able to service its future payments on that debt.
- They are used to evaluate a company’s capital structure. For example, the Debt-to-Assets ratio is an indicator of the company’s debt relative to its assets. Similarly, the Assets-to-Equity ratio can be used to measure its assets versus stockholder equity. Together, both ratios provide a window into the company’s spending and debt allocations.

## How Companies use Leverage Ratios

While a score of 1 is the ideal leverage ratio for companies, some industries have ratios greater than 1 due to the nature of their operations.

For example, companies in the manufacturing and retail sector have leverage ratios much greater than 1 because they need high inventory numbers, which are included in debt calculations, to operate efficiently.

As such, it is always better to compare leverage ratios between companies in a particular industry instead of comparing them across industries.