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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.
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.