Course 304: Interpreting the Numbers
Leverage Ratios
In this course
1 Introduction
2 How to Use Financial Ratios
3 Efficiency Ratios
4 Liquidity Ratios
5 Leverage Ratios
6 Profitability Ratios
7 The Bottom Line

A company's leverage relates to how much debt it has on its balance sheet, and it is another measure of financial health. Generally, the more debt a company has, the riskier its stock is, since debtholders have first claim to a company's assets. This is important because, in extreme cases, if a company becomes bankrupt, there may be nothing left over for its stockholders after the company has satisfied its debtholders.

Debt/Equity. The debt/equity ratio measures how much of the company is financed by its debtholders compared with its owners. A company with a ton of debt will have a very high debt/equity ratio, while one with little debt will have a low debt/equity ratio. Assuming everything else is identical, companies with lower debt/equity ratios are less risky than those with higher such ratios.

Debt/Equity = (Short-Term Debt + Long-Term Debt) / Total Equity

Interest Coverage. If a company borrows money in the form of debt, it most likely incurs interest charges on it. (Money isn't free, after all!) The interest coverage ratio measures a company's ability to meet its interest obligations with income earned from the firm's primary source of business. Again, higher interest coverage ratios are typically better, and interest coverage close to or less than one means the company has some serious difficulty paying its interest.

Interest Coverage = (Operating Income) / (Interest Expense)

Next: Profitability Ratios >>


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