What Can Leverage Ratio Tell You about a Company?

Leverage ratio is used by investors to gain insight about a company’s financial methods as well as its ability to repay its debts. The term leverage, also known as gearing, pertains to the use of debts to fund investments or acquisitions, with the hope that the rate of return from the investment is higher than the rate of interest on the debts. Investing in companies that are highly leveraged is considered risky by many investors because such companies are very much vulnerable to economic declines, as they need to pay off their debts despite decreasing sales and production. Below are the most common types of leverage or gearing ratio formulas that are important to most investors.

Debt Ratio

This type of leverage ratio is also known as debt-to-asset ratio and it is used to determine what percentage of a company’s total assets is backed by debts. You can get this ratio by dividing the total debts of the company by its total assets. This ratio will show if the company is financially healthy and capable of repaying its long-term financial obligations. A high debt ratio will tell you that a company relies heavily on debts and loans to continue its operations. If the debt ratio is higher than 1, the company has more debts than assets.

Debt-to-Equity Ratio

The debt-to-equity ratio (D/E), also known as the financial leverage ratio, is used by investors to determine the financial standing of a company. This ratio will show if an entity is reliant on debt financing. You can get the D/E ratio by dividing the total liabilities by shareholders' equity or capital. A low D/E ratio is indicative of financial strength because it means that the capital provided by the shareholders can serve as a safety net in case of economic downturns. Despite a dip in sales and revenue, a company with a low D/E ratio can meet its long-term liabilities because it has ample shareholder capitalization.

Most investors make use of this ratio in computing for the degree of risks involved when putting money on a company’s stocks or bonds. This will also determine if the interest rate of the bonds issued by a company is high enough to attract investors or buyers, notwithstanding the company’s reliance on debts for continued operations.

Interest Coverage Ratio

This type of leverage ratio shows the ease or difficulty with which a company can afford to pay interest associated with its financial obligations. You can get the interest coverage ratio by dividing earnings before interest and taxes by interest expense. This ratio is used by investors to find out the short-term financial health of the company. As a general rule, a company that has an interest coverage ratio of 1 or lower may have problems generating enough cash to settle its interest payments.

Although leverage ratios can help outline a company’s financial health, investors should not rely solely on them when making investment decisions. There are other factors, such as historical financial data, that can help you make a smart investment decision.

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