Leverage ratio: Meaning, Formula and How to Calculate

Have you ever wondered how companies manage to expand or make investments even if they don't have much cash on hand? This happens due to something called leverage, which, in simpler terms, means borrowing money to seek to grow faster. Understanding leverage ratio can help you make better investment decisions. But what is leverage ratio and why is it important? Let's take a closer look at this interesting financial concept.

Table of contents

• What is leverage ratio?
• Leverage ratio formula and how to calculate
• Example of leverage ratio calculation
• Types of leverage ratios
• What does a leverage ratio tell you?
• Advantages and disadvantages of financial leverage
• What is a good leverage ratio?
• Leverage ratio vs. coverage ratio: What’s the difference?
• Leverage ratio in banking and regulatory context
• Leverage ratio and mutual funds
• Common mistakes when interpreting leverage ratios

What is leverage ratio?

A leverage ratio is a simple financial measure that shows how much a company borrows compared to its own money (equity). Leverage ratio indicates how much of the company's money comes from debt, like loans, and how much comes from its own funds, like profits or shareholder investments.

• High leverage ratio: More borrowing, higher risk.
• Low leverage ratio: Less borrowing, potentially lower risk.

Knowing the meaning of leverage ratio can help investors understand how risky a company could be to invest in.

Read Also: How arbitrage funds leverage market volatility

Leverage ratio formula and how to calculate

The basic leverage ratio formula is quite straightforward:

Leverage Ratio = Total Debt / Total Equity

• Total debt: All the money borrowed by the company (like loans, bonds).
• Total equity: The company's own money (like shareholders' funds).

Here's a simple method that tells you how to calculate leverage ratio:

1. Find out the company's total debt from its financial statement.
2. Find out the company's total equity from the same statement.
3. Use the formula given above and divide total debt by total equity.
4. The answer you get is the leverage ratio.

Example of leverage ratio calculation

To make it clear, let’s look at an easy example:

• Suppose a company has:
  • Total debt = Rs. 50 lakh
  • Total equity = Rs. 25 lakh

Now, let's calculate the leverage ratio:

Leverage Ratio = Rs. 50,00,000 / Rs. 25,00,000 = 2

So, we conclude that the company has a leverage ratio of 2. This means that the company has borrowed twice as much as its own money.

Types of leverage ratios

Commonly used leverage ratios include the following:

• Debt to equity ratio: This ratio compares total debt with shareholders’ equity. It indicates the extent to which a company relies on borrowed funds versus owner capital. A higher ratio suggests greater dependence on debt, which may increase financial risk.
• Debt to assets ratio: This measures the proportion of a company’s assets financed through debt. It helps evaluate how much of the asset base is funded by liabilities rather than equity.
• Equity ratio: The equity ratio reflects the share of assets funded by shareholders’ equity. A higher equity ratio may indicate relatively lower financial leverage.
• Interest coverage ratio: This ratio assesses a company’s ability to meet interest obligations from operating earnings. It provides insight into short-term debt servicing capacity.
• Debt to EBITDA ratio: This compares total debt to earnings before interest, tax, depreciation, and amortisation. It is often used to understand how long a company may take to repay debt from operating earnings.

What does a leverage ratio tell you?

Leverage ratio helps you understand the financial strength of a company:

• High leverage ratio: Shows the company relies heavily on borrowed money, which can indicate higher growth potential but might be risky if profits decline.
• Low leverage ratio: Indicates the company mainly uses its own money, making it relatively lower risk during difficult economic times.

Advantages and disadvantages of financial leverage

Advantages:

• Helps companies grow quickly without needing large amounts of their own cash.
• Allows businesses to expand and earn higher profits.

Disadvantages:

• Too much debt can lead to financial stress.
• Risk of bankruptcy if the company cannot repay loans.

What is a good leverage ratio?

Generally speaking:

• A good leverage ratio is usually below 2.
• A ratio of 1 or lower is considered excellent.
• Ratios above 3 might signal higher risk.

However, what’s considered a "good" leverage ratio also depends on the industry. Companies like banks naturally have higher leverage, while tech companies usually have lower leverage.

Leverage ratio vs. coverage ratio: What’s the difference?

Both metrics indicate a company’s financial health, but there are some key differences, as follows:

• Leverage ratio: Measures how much a company is using debt compared to its own equity or assets. It shows how heavily the company relies on borrowed money.
• Coverage ratio: Measures whether a company generates enough earnings to comfortably pay its debt obligations (like interest or loan repayments). It reflects how well the company can manage its existing debt.

Leverage ratio in banking and regulatory context

In the banking sector, the leverage ratio is a regulatory measure used to assess a bank’s capital strength relative to its overall exposure. Unlike risk-weighted capital ratios, the leverage ratio does not adjust assets based on risk. Instead, it applies a simple, non-risk-based framework to ensure banks maintain a minimum level of capital against total exposures.

The primary objective of the leverage ratio is to limit excessive balance sheet expansion and reduce the build-up of systemic risk. By placing a floor on leverage, regulators aim to ensure that banks remain resilient even if risk models underestimate actual exposure during periods of financial stress.

Key regulatory considerations include:

• It complements, not replaces, risk-weighted capital adequacy ratios
• It enhances comparability across banks by using a standard exposure measure
• It supports financial system stability by curbing excessive leverage

Leverage ratio and mutual funds

You may wonder how leverage ratio is connected to mutual funds. Those who invest in mutual fund can also benefit from understanding leverage ratios. Mutual funds that invest in companies with low leverage ratios tend to be safer investments, while those investing in high-leverage companies may have higher risk but potentially higher returns. Because mutual funds are professionally managed, fund managers look out for factors like leverage ratio while making investment decisions.

Common mistakes when interpreting leverage ratios

One common mistake is comparing leverage ratios across different industries without considering business models. Capital-intensive sectors such as infrastructure or utilities typically operate with higher debt levels than asset-light businesses. Direct comparisons without industry context may distort risk assessment.

Another frequent issue is focusing only on a single leverage ratio. Each ratio highlights a different aspect of debt usage, and relying on just one may overlook broader financial risks. A balanced view usually requires examining multiple leverage measures together.

A few more common mistakes include:

• Overlooking changes in leverage trends over time
• Ignoring off-balance-sheet obligations
• Not adjusting for one-time earnings or exceptional items
• Assuming lower leverage always indicates lower financial risk

Read Also: What are leveraged ETFs and are they worth the risk?

Conclusion

Understanding the concept of leverage ratio can be valuable for an investor. A suitable balance of debt and equity can lead to growth, while too much debt can be risky. By calculating and regularly checking this ratio, investors can make wiser investment decisions and keep their money safer.

Frequently Asked Questions

How can the leverage ratio be improved?

A company can improve its leverage ratio by increasing profits and using them to pay off debt, issuing more shares to raise equity, and minimising use of borrowed money for future growth.

Is there a way to lower the leverage ratio?

A company can lower its leverage ratio by paying off existing loans or debts quickly, increasing its profits or income, while also making sure to avoid taking new loans until finances are more stable.

How does leverage ratio affect investment decisions?

The leverage ratio can help investors assess a company’s financial risk and sensitivity to economic conditions. Higher leverage may amplify both potential gains and losses, increasing vulnerability during periods of earnings volatility or economic stress. Lower leverage generally indicates a more conservative capital structure, which may reduce financial strain, though growth prospects may depend on the company’s ability to deploy capital efficiently across different business cycles.

What is a suitable leverage ratio in different industries?

There is no universally acceptable leverage ratio across industries. Capital intensive sectors like utilities or infrastructure may operate with higher leverage, while technology or service firms may maintain lower leverage. Suitable levels depend on cash flow stability, regulatory norms, business cycles, and access to long-term funding conditions and market expectations.

What is the difference between leverage ratio and coverage ratio?

A leverage ratio measures the proportion of debt in a company’s capital structure, reflecting balance sheet risk. A coverage ratio evaluates a firm’s ability to service obligations using earnings or cash flows. Together, they provide insights into a firm’s potential solvency, repayment capacity, and overall financial sustainability under varying operating conditions scenarios.

Can a company have too low a leverage ratio? What are the implications?

A very low leverage ratio may indicate limited use of borrowed capital. While this reduces financial obligations, it may also constrain expansion or efficiency if external funding could support growth. Investors may interpret extremely low leverage as conservative capital management or missed potential opportunities depending on industry context and strategy.