The financial leverage ratio is also known as equity or debt ratio as they can measure the assets of a company relative to its equity. In other words, it is the key to measure business solvency– the ability of a business to meet its long-term fixed financial expenditures and to achieve long-term business growth. Therefore, financial leverage ratios also called long-term solvency ratios. Business solvency ratios mainly focus on the long-term ability of a business to pay off its liabilities.
If a business can obtain a higher return than the debt it holds, the business is said to be less leveraged. Otherwise, the business’ debt outweighs the return from its assets.
Then the business is considered highly leveraged. If this situation continues for a long-term, it may lead to bankruptcy. Therefore, investors should be aware of a company’s financial leverage ratio while investing.
The degree of financial leverage of a company depends on many factors such as the availability of fixed-income securities, and the strength of cash flow. The financial leverage of a company shows the debt as part of its financial plan. It also tells about the company’s dependency on borrowings. Financial leverage ratios facilitate the businesses to determine how they can meet their long-term financial liabilities.
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Here are the most important financial leverage ratios:
The debt ratio is one of the financial leverage ratios that measure the ratio of a company’s total debt against the total asset. If the debt ratio is lower, the company is less leveraged and has a strong equity position. The company is highly leveraged if higher its debt ratio. An investor should double check their decision while choosing highly leveraged companies to invest. The debt ratio of a company can calculate by dividing its total liabilities with total assets. It is shown in decimal numbers as it assumes the overall debt as a percentage of its total assets. The debt ratio is the fundamental business solvency ratio because investors, creditors, and banks are always concerned about the company’s ability to pay them.
Debt to Equity Ratio
Debt to equity ratio plays an important role in determining a company’s leverage position. It is the percentage of shareholders’ equity against total debt used to finance a company. The debt to equity ratio indicates the percentage of financing that comes from both creditors and investors. If the creditor financing is higher than the investor financing, the debt to equity ratio will be higher. It is calculated by dividing the company’s total debt by its total equity. Companies with a higher debt to equity ratio indicates that companies are at high risk than the companies with lower debt to equity ratio. Debt financing is different from equity financing as debt financing required to make regular payments of interest.
The equity ratio is a significant business solvency ratio that compares the total equity of a company to the total assets. It mainly focuses on two significant financial concepts of a sustainable business. The first concept indicates how much assets owned by investors out of a company’s total asset. The second concept points out how the company is leveraged with debt. If the equity ratio is higher, investors and creditors will be more willing to finance that particular company with their investments. Companies with a higher equity ratio usually have less financial leverage.