Financial Leverage Ratio

The Financial Leverage ratio provides an insight into the strength of a company’s finances. It indicates the extent of reliance on external financing. The financial leverage ratio is also called the debt to equity ratio. The Debt to Equity Ratio measures the amount that a company would safely be able to borrow and service safely. It does this by comparing the company’s total obligations and dividing it by the amount of owner’s equity.

Financial Leverage ratio = (All Liabilities)/(Stock holder’s Equity)

Stock holder’s equity includes Long term assets the company owns, plus any claims it has against other firms. Liabilities will include both current and long-term liabilities.

The figures of liabilities and Stock holder’s Equity are taken from the balance sheet or statement of financial position, while computing the value of the Financial Leverage ratio. We can also compute the ratio using market values for both, if the company’s debt and equity are publicly traded, or using a combination of book value for debt and market value for equity.

We can also use this Leverage ratio to compare companies in the same domain. Arguably, the upper acceptable threshold of the financial leverage ratio is generally 2:1, and over a long term it should come down to 1:3.

The Debt to Equity Ratio is closely observed and tracked by both creditors and investors, because it reveals the extent to which company is funding its operations with borrowed money, instead of using own funds (equity). In the event of an excessively high percentage of debt as compared to equity, the creditors run the risk of loans not being repaid.