Leverage Ratios

Leverage ratios are financial metrics used to assess a company’s ability to meet its financial obligations by comparing its debt levels to equity or assets. These ratios help investors and analysts understand the level of financial risk a company carries, as higher leverage indicates greater reliance on borrowed funds. Companies use leverage strategically to amplify returns, but excessive leverage can lead to financial distress if earnings are insufficient to cover debt payments. Different types of leverage ratios provide insights into various aspects of a company’s financial structure, including equity reliance, overall capital composition, and long-term debt obligations.

The definition of these ratios are:

Common Equity Leverage
Net Income / (Net Income + (Interest Expense (1 – Tax Rate)))
Measures the proportion of a company’s total assets financed by common equity, showing how much of the business is supported by shareholder investment.

Capital Structure Leverage
(Cash + Marketable Securities + Net Accounts Receivable)/Current Liabilities
Assesses the extent to which a company’s capital structure relies on debt versus equity, indicating financial risk and funding strategy.

Debt/Equity Ratio
(Net Income + Tax Expense + Interest Expense)/Interest Expense
Compares total debt to shareholders’ equity, highlighting the balance between borrowed funds and owner’s capital in financing operations.

Long-Term Debt Ratio
Cost of Goods Sold / Average Accounts Payable
Evaluates the portion of a company’s total capitalization that comes from long-term debt, reflecting the company’s dependence on long-term borrowings for funding.