Leverage Ratio

Leverage Ratio

In risk analysis, any ratio that measures a company's leverage. One example of a gearing ratio is the long-term debt/capitalization ratio, which is calculated by taking the company's long-term debt and dividing it by its long-term debt added to its preferred and common stock. Another example is a simple debt-to-equity ratio, which is calculated by dividing total debt by total equity. Generally, companies with higher leverage as determined by a leverage ratio are thought to be more risky because they have more liabilities and less equity. A leverage ratio is also called a gearing ratio.

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Leverage Ratio

What Does Leverage Ratio Mean?

(1) Any ratio used to calculate the financial leverage of a company to get an idea of that company's methods of financing or measure its ability to meet its financial obligations. There are several ratios, but the main factors evaluated by a ratio include debt, equity, assets, and interest expenses. (2) A ratio used to measure a company's mix of operating costs that yields an approximation of how changes in output will affect operating income. Fixed costs and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ.

Investopedia explains Leverage Ratio

(1) The best-known financial leverage ratio is the debt-to-equity ratio. For example, if a company has $10 million in debt and $20 million in equity, it has a debt-to-equity ratio of 0.5 ($10 million/$20 million).

(2) Companies with high fixed costs, after reaching the breakeven point, see a greater increase in operating revenue when output is increased compared with companies with high variable costs. The reason for this is that the costs already have been incurred, and so every sale above breakeven transfers to the operating income. In contrast, a company with high variable costs sees little increase in operating income with additional output, because costs continue to rise as outputs rise. The degree of operating leverage is the ratio used to calculate this mix and its effects on operating income.

Related Terms:
• Debt Financing
• Debt Ratio
• Deleverage
• Leverage
• Operating Leverage