Leverage Ratios

Leverage ratios refer to the ratios that are used to calculate company’s financial leverage. This ratio helps to get an idea about the financing methods of the company. This ratio also gives the measurement of a company’s ability to meet the financial liabilities. The leverage ratios are also known as the debt to equity ratios.
Various ratios are available to measure the strategic efficiency of the company. The major factors that are observed through these ratios mainly include equity, debt, interest expenses and assets of the company. It can also be said that the leverage ratios actually give the measurement of various operating costs of the company.

This also gives some understanding on how some modifications in the company output can affect the company’s operating income. The operating costs of a company are referred to as fixed costs and variable costs of the company. Depending on which industry the company belongs the mix of operating costs varies.
The companies that are having high fixed costs after attaining a level where neither gain nor loss is achieved find that the operating revenue has increased immensely in comparison with the high variable cost of the company.
This happens because the companies have already received the cost and hence all the sales occurring after the breakeven is shifted to the operating income. But the companies that are having high variable cost do not find much increment in the operating income of the company with the extra output as the costs are assigned into the outputs. The operating leverage degree gives the ratio that is used to measure this mix and also to estimate the effect of the mix on the operating income.

Here is the mathematical representation of leverage ratio or debt to equity ratio:

Debt to Equity Ratio (leverage ratio) = (Long Term Debt + Short Term Debt) / Total Equity of Shareholders .

Debt to equity ratio is also often referred to as financial leverage ratio or simply debt ratio. In other words, the financial leverage ratio gives the measurement of the degree to which the company depends on the debt financing. A high value of debt to equity ratio or financial leverage infers the possibility of difficulty that the company will face while paying the principal amount and interest when going for funding. The highest value of debt to equity ratio that is acceptable is 2:1.

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Last Updated on : 27th June 2013

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