Leverage Ratio
Leverage Ratio refers to a financial measurement that assesses the ability of a company to meet its financial obligations. It is calculated by comparing a company’s debt to its Equity or Assets, indicating the degree to which a company is utilizing borrowed Money to finance its operations.
Common types of leverage ratios include:
- Debt-to-Equity Ratio: This ratio compares total liabilities to Shareholders’ Equity. A higher ratio indicates greater financial risk.
- Debt Ratio: This ratio measures total debt as a percentage of total Assets, showing how much of the company’s Assets are financed by debt.
- Equity-multiplier/">Equity Multiplier: This ratio is calculated by dividing total Assets by total Equity, reflecting the proportion of a company’s Assets that are financed by Shareholders’ Equity versus debt.
Examples:
- If a company has total debt of $500,000 and total Equity of $250,000, its Debt-to-Equity Ratio is 2.0, indicating it has twice as much debt as Equity.
- A company with total Assets of $1 million and total liabilities of $400,000 has a Debt Ratio of 40%, meaning 40% of its Assets are financed through debt.
- An Equity-multiplier/">Equity Multiplier of 3 means that for every dollar of Equity, the company has three dollars in Assets, suggesting a higher reliance on debt financing.
Cases:
- In a recession, a company with a high leverage ratio may struggle to meet its debt obligations, potentially leading to Bankruptcy.
- A startup may have a high leverage ratio as it borrows heavily to finance growth, but this also increases financial risk.