Leverage ratios are used to determine the relative level of debt load that a business has incurred. These ratios compare the total debt obligation to either the assets or equity of a business. A high ratio indicates that a business may have incurred a higher level of debt than it can be reasonably expected to service with ongoing cash flows.
The two main leverage ratios are:
- Debt ratio. Compares assets to debt, and is calculated as total debt divided by total assets. A high ratio indicates that the bulk of asset purchases are being funded with debt.
- Debt to equity ratio. Compares equity to debt, and is calculated as total debt divided by total equity. A high ratio indicates that the business owners may not be providing sufficient equity to fund a business.
Leverage ratios are essentially measures of risk, since a borrower that cannot pay back its debt obligations is at considerable risk of entering bankruptcy protection. However, a modest amount of leverage can be beneficial to shareholders, since it means that a business is minimizing its use of equity to fund operations, which increases the return on equity for existing shareholders.
A prospective lender may use leverage ratios as part of its analysis of whether to lend funds to a business. However, these ratios do not provide sufficient information for a lending decision. A lender also needs to know if a business is generating sufficient cash flows to pay back debt, which involves a review of both the income statement and statement of cash flows. A lender will also review a company's budget, to see if projected cash flows can continue to support ongoing debt payments.
In addition, the nature of the industry in which a business is located plays a significant role in the lending decision. For example, if an industry has few competitors, there are high barriers to entry, and there is a long history of above-average profits, then an organization could probably maintain a high debt load over a long period of time. Conversely, in an industry where market share changes continually, product cycles are short, and capital investment requirements are high, it is quite difficult to have stable cash flows - and lenders will be less inclined to lend money.
In short, leverage ratios are used for a portion of the analysis when determining whether to lend money, but a great deal of additional information is needed before a lending decision can be made.