Month End Glossary

Leverage Ratio

The leverage ratio is a financial metric that measures the degree to which a firm uses borrowed funds, or debt, to finance its operations, assets, or investments.

The leverage ratio is a critical measure in financial analysis and corporate finance, helping businesses and stakeholders assess the financial health of a company. It is calculated by dividing a company's total debt by its equity or by its total assets; alternatively, it can take other forms depending on what is used for the numerator and denominator. A higher leverage ratio indicates a greater reliance on debt financing, which can amplify both potential returns and risks, as more debt incurs higher mandatory repayments and interest outflows.

For example, if a company has $200,000 in total debt and $500,000 in total equity, its debt-to-equity leverage ratio would be 0.4 (200,000 / 500,000). Understanding a company's leverage ratio is essential for investors, creditors, and other stakeholders, as it provides insight into how the company balances financial risk and potential growth opportunities.

Leverage is often desired up to a certain level as it indicates the firm is utilizing external funding effectively; however, excessive leverage represents financial risk, as the company may struggle to meet its obligations during downturns. Comparison of a firm's leverage ratio against peers and industry standards offers a better understanding of its relative financial position.

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