Leverage Ratios (2024)

A class of ratios that measure the indebtedness of a firm

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What are Leverage Ratios?

A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. These ratios provide an indication of how the company’s assets and business operations are financed (using debt or equity). Below is an illustration of two common leverage ratios: debt/equity and debt/capital.

Leverage Ratios (1)

List of common leverage ratios

There are several different leverage ratios that may be considered by market analysts, investors, or lenders. Some accounts that are considered to have significant comparability to debt are total assets, total equity, operating expenses, and incomes.

Below are 5 of the most commonly used leverage ratios:

  1. Debt-to-Assets Ratio = Total Debt / Total Assets
  2. Debt-to-Equity Ratio = Total Debt / Total Equity
  3. Debt-to-Capital Ratio = Total Debt / (Total Debt + Total Equity)
  4. Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
  5. Asset-to-Equity Ratio = Total Assets/ Total Equity

Leverage ratio example #1

Imagine a business with the following financial information:

  • $50 million of assets
  • $20 million of debt
  • $25 million of equity
  • $5 million of annual EBITDA
  • $2 million of annual depreciation expense

Now calculate each of the 5 ratios outlined above as follows:

  1. Debt/Assets = $20 / $50 = 0.40x
  2. Debt/Equity = $20 / $25 = 0.80x
  3. Debt/Capital = $20 / ($20 + $25) = 0.44x
  4. Debt/EBITDA = $20 / $5 = 4.00x
  5. Asset/Equity = $50 / $25 = 2.00x

Leverage Ratios (2)

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Leverage ratio example #2

If a business has total assets worth $100 million, total debt of $45 million, and total equity of $55 million, then the proportionate amount of borrowed money against total assets is 0.45, or less than half of its total resources. When comparing debt to equity, the ratio for this firm is 0.82, meaning equity makes up a majority of the firm’s assets.

Importance and usage

Leverage ratios represent the extent to which a business is utilizing borrowed money. It also evaluates company solvency and capital structure. Having high leverage in a firm’s capital structure can be risky, but it also provides benefits.

The use of leverage is beneficial during times when the firm is earning profits, as they become amplified. On the other hand, a highly levered firm will have trouble if it experiences a decline in profitability and may be at a higher risk of default than an unlevered or less levered firm in the same situation.

Finally, analyzing the existing level of debt is an important factor that creditors consider when a firm wishes to apply for further borrowing.

Essentially, leverage adds risk but it also creates a reward if things go well.

What are the various types of leverage ratios?

1. Operating leverage

An operating leverage ratio refers to the percentage or ratio of fixed costs to variable costs. A company that has high operating leverage bears a large proportion of fixed costs in its operations and is a capital intensive firm. Small changes in sales volume would result in a large change in earnings and return on investment.

A negative scenario for this type of company could be when its high fixed costs are not covered by earnings because the market demand for the product decreases. An example of a capital-intensive business is an automobile manufacturing company.

If the ratio of fixed costs to revenue is high (i.e., >50%) the company has significant operating leverage. If the ratio of fixed costs to revenue is low (i.e., <20%) the company has little operating leverage.

2. Financial leverage

A financial leverage ratio refers to the amount of obligation or debt a company has been or will be using to finance its business operations. Using borrowed funds, instead of equity funds, can really improve the company’s return on equity and earnings per share, provided that the increase in earnings is greater than the interest paid on the loans. Excessive use of financing can lead to default and bankruptcy. See the most common financial leverage ratios outlined above.

3. Combined leverage

A combined leverage ratio refers to the combination of using operating leverage and financial leverage. For example, when viewing the balance sheet and income statement, operating leverage influences the upper half of the income statement through operating income while the lower half consists of financial leverage, wherein earnings per share to the stockholders can be assessed.

How is leverage created?

Leverage is created through various situations:

  • A company takes on debt to purchase specific assets. This is referred to as “asset-backed lending” and is very common in real estate and purchases of fixed assets like property, plant, and equipment (PP&E).
  • A company borrows money based on the overall creditworthiness of the business. This is usually a type of “cash flow loan” and is generally only available to larger companies.
  • When a company borrows money to finance an acquisition (learn more about the mergers and acquisitions process).
  • When a private equity firm (or other company) does a leveraged buyout (LBO).
  • When an individual deals with options, futures, margins, or other financial instruments.
  • When a person purchases a house and decides to borrow funds from a financial institution to cover a portion of the price. If the property is resold at a higher value, a gain is realized.
  • Equity investors decide to borrow money to leverage their investment portfolio.
  • A business increases its fixed costs to leverage its operations. Fixed costs do not change the capital structure of the business, but they do increase operating leverage which will disproportionately increase/decrease profits relative to revenues.

What are the risks of high operating leverage and high financial leverage?

If leverage can multiply earnings, it can also multiply risk. Having both high operating and financial leverage ratios can be very risky for a business. A high operating leverage ratio illustrates that a company is generating few sales, yet has high costs or margins that need to be covered. This may either result in a lower income target or insufficient operating income to cover other expenses and will result in negative earnings for the company.

On the other hand, high financial leverage ratios occur when the return on investment (ROI) does not exceed the interest paid on loans. This will significantly decrease the company’s profitability and earnings per share.

Coverage ratios

Besides the ratios mentioned above, we can also use the coverage ratios in conjunction with the leverage ratios tomeasure a company’s ability to pay itsfinancial obligations.

The most common coverage ratios are:

  1. Interest coverage ratio:The ability of a company to pay theinterest expense(only) on its debt
  2. Debt service coverage ratio: The ability of a company to pay all debt obligations, including repayment of principal and interest
  3. Cash coverage ratio:The ability of a company to pay interest expense with its cash balance
  4. Asset coverage ratio:The ability of a company to repay its debt obligations with its assets

Additional Resources

This leverage ratio guide has introduced the main ratios, Debt/Equity, Debt/Capital, Debt/EBITDA, etc. Below are additional relevant CFI resources to help you advance your career.

Leverage Ratios (2024)


What is considered a good leverage ratio? ›

A financial leverage ratio of less than 1 is usually considered good by industry standards. A leverage ratio higher than 1 can cause a company to be considered a risky investment by lenders and potential investors, while a financial leverage ratio higher than 2 is cause for concern.

How do I calculate leverage ratio? ›

You can calculate this metric by dividing the total debt—both short-term and long-term, by total assets. With this measurement, you can better evaluate how financially stable a company is, and use this metric to compare other companies within the same industry.

What are the limitations of leverage ratios? ›

A limitation of using the Tier 1 leverage ratio is that investors are reliant on banks to properly and honestly calculate and report their Tier 1 capital and total assets figures. If a bank doesn't report or calculate its figures properly, the leverage ratio could be inaccurate.

What is a 1 5 leverage ratio? ›

Examples of leverage in trading

You have $100 to trade but you want to increase your potential return. If your broker offers leverage of 1:5, with their backing, you could manage a position of up to $500, with a margin of $100.

How much leverage is enough? ›

If you are conservative and don't like taking many risks, or if you're still learning how to trade currencies, a lower level of leverage like 5:1 or 10:1 might be more appropriate. Trailing or limit stops provide investors with a reliable way to reduce their losses when a trade goes in the wrong direction.

How to interpret leverage ratio? ›

A high operating leverage ratio illustrates that a company is generating few sales, yet has high costs or margins that need to be covered. This may either result in a lower income target or insufficient operating income to cover other expenses and will result in negative earnings for the company.

What is a leverage ratio example? ›

Common types of leverage ratios

Debt to assets ratio= Total Debt / Total Assets. Debt to equity ratio = Total Debt / Total Equity. Debt to capital ratio = Today Debt / (Total Debt + Total Equity) Debt to EBITDA ratio= Total Debt / Earnings Before Interest Taxes Depreciation and Amortization (EBITDA)

What is the leverage ratio for beginners? ›

As a new trader, you should consider limiting your leverage to a maximum of 10:1. Or to be really safe, 1:1. Trading with too high a leverage ratio is one of the most common errors made by new forex traders. Until you become more experienced, we strongly recommend that you trade with a lower ratio.

How to improve leverage ratio? ›

A business can increase its leverage in a number of ways. The most obvious approach is to take on more debt through a line of credit, where the debt reflects a general increase in the obligations of a firm.

Is a high leverage ratio risky? ›

Leverage ratios like the Debt-to-Equity Ratio reflect a company's reliance on debt compared to its equity. A higher ratio generally indicates a higher risk due to increased reliance on borrowed funds.

Why is high leverage ratio bad? ›

A high debt/equity ratio generally indicates that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If the company's interest expense grows too high, it may increase the company's chances of a default or bankruptcy.

What is too much leverage? ›

Overleveraging occurs when a business has borrowed too much money and is unable to pay interest payments, principal repayments, or maintain payments for its operating expenses due to the debt burden.

What is a 1 10 leverage ratio? ›

Using the example from earlier, a 10% margin would provide the same exposure as a £1000 investment with just £100 margin. This gives a leverage ratio of 10:1. Often the more volatile or less liquid an underlying market, the lower the leverage on offer in order to protect your position from rapid price movements.

What is a 30 to 1 leverage ratio? ›

Leverage is described as a ratio or multiple.

So, for example, trading using leverage of 30:1 means that for every US$1 of available margin that you have in your account, you can place a trade worth up to US$30.

What is a 1 20 leverage ratio? ›

In conclusion, 1:20 leverage in forex means that for every dollar a trader deposits into their account, they can control $20 worth of currency. It is a powerful tool that allows traders to participate in the market even with limited capital and potentially generate larger profits from small price movements.

Is 1 500 leverage ratio good? ›

A leverage ratio of 1:500 offers significant amplification of your trading position. With this level of leverage, a small investment can control positions that are 500 times larger. While the potential for profit is substantial, it's crucial to exercise caution and have a robust trading strategy in place.

What does a leverage ratio of 0.5 mean? ›

A D/TA ratio of 0.5 (this can also be expressed as 50%) indicates that half of a company's assets were financed with debt and half were financed with equity.

Is a 1 1 leverage good? ›

1:1 Forex Leverage Ratio

This makes the 1:1 ratio the best leverage to use in forex, especially for beginners who want to start with large capital. However, if you use this leverage, you are risking 1% for every trading position you open.

Is 1 500 leverage good? ›

1:500 is an extremely high leverage. You would only need a trade to go slightly against you and your whole account will be wiped out. Remember, your LOSSES ARE MULTIPLIED BY 500 as well as your gains.


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