5 Financial Leverage Ratios in 24 Minutes
Financial leverage ratios show how much a company relies on borrowed money and how easily it can cover the interest. Three ratios measure the debt load on the balance sheet, and two coverage ratios check whether operating profit comfortably pays the lenders.
Financial leverage ratios explained simply
Leverage ratios show how much a company relies on borrowed money and whether its profits cover the interest. Balance-sheet ratios (debt ratio, debt-equity, equity multiplier) measure the debt load; coverage ratios (times interest earned, cash coverage) check the ability to pay. In the example, debt is 60% of assets and operating profit covers interest 5 times.
What this leverage ratios lesson covers
- How the total debt ratio and debt-equity ratio measure borrowing
- Why the equity multiplier equals 1 plus the debt-equity ratio
- How times interest earned tests the ability to pay interest
- Why cash coverage adds back depreciation to EBIT
- Why more leverage raises both potential returns and risk
Leverage ratio formulas, explained
- Total assets − Total equity
- All liabilities, short-term and long-term
- Total debt
- Total liabilities
- Total equity
- Shareholders' equity
- EBIT
- Earnings before interest and taxes
- Depreciation
- Non-cash expense added back to get closer to cash
- Interest
- Interest expense for the year
How to calculate leverage ratios step by step (worked example)
A company has total assets of $1,000, total equity of $400, EBIT of $150, depreciation of $50 and interest expense of $30. Find its five leverage ratios.
- Total debt = 1,000 − 400 = 600, so total debt ratio = 600 ÷ 1,000 = 0.60
- Debt-equity ratio = 600 ÷ 400 = 1.5
- Equity multiplier = 1,000 ÷ 400 = 2.5 (check: 1 + 1.5 = 2.5)
- Times interest earned = 150 ÷ 30 = 5 times
- Cash coverage = (150 + 50) ÷ 30 ≈ 6.67 times
Answer: Debt ratio 0.60, D/E 1.5, equity multiplier 2.5, TIE 5 times, cash coverage about 6.67 times (rounded to 2 decimals).
Debt-load ratios vs coverage ratios
| Debt-load ratios | Coverage ratios | |
|---|---|---|
| Examples | Debt ratio, debt-equity, equity multiplier | Times interest earned, cash coverage |
| What they measure | How much of the company is funded by debt | How easily profit pays the interest |
| Comes from | The balance sheet | The income statement |
| In the example | 0.60, 1.5 and 2.5 | 5 times and about 6.67 times |
| Warning sign | Debt rising much faster than equity | Coverage close to 1 |
Is less debt always safer? David's take
Times interest earned of 5 means operating profit could fall by 80% and the company could still pay its interest. That's what controlled debt looks like. I consider myself a responsible finance guy, and for years I believed being debt-free was simply the responsible choice. Now it looks to me like owning a car and never using it. Debt is like fire: it can become deadly if you don't control it, but refusing to use it at all is bizarre. These ratios are how you check that the fire is under control.
From David's concept: Reconsidering the Debt-Free Convention. This is David's opinion, alongside the standard textbook answer above.
Harder leverage ratio questions
How far can EBIT fall before the interest isn't covered?
With EBIT of $150 and interest of $30, EBIT can drop to $30, a fall of 80%, before times interest earned hits 1. That cushion says more about safety than the debt ratio alone.
Can a company with a low debt ratio still be in danger?
Yes. If profits are small or volatile, even modest interest can be hard to pay, and debt that falls due soon has to be refinanced. Always read the debt ratio together with coverage and with when the debt matures.
Why does a higher equity multiplier raise ROE?
ROE = ROA × equity multiplier. With the same return on assets, a company funded with more debt has less equity, so each dollar of profit is spread over a smaller base. The same lever magnifies losses, which is why leverage raises both potential returns and risk.
Common leverage ratio questions
What is the difference between the debt ratio and the debt-to-equity ratio?
The total debt ratio divides debt by total assets, so it shows what share of the assets is financed by borrowing. The debt-to-equity ratio divides debt by equity, so it shows how many dollars of debt there are for each dollar the owners put in.
How do you calculate the equity multiplier?
Divide total assets by total equity. Because assets equal debt plus equity, the equity multiplier always equals 1 plus the debt-equity ratio. A multiplier of 2.5 means every $1 of equity supports $2.50 of assets.
What is a good times interest earned ratio?
There is no single cutoff, but higher is safer. A ratio of 5 means EBIT covers interest five times over. A ratio close to 1 means almost all operating profit goes to lenders, which leaves little room if sales drop.
Why does the cash coverage ratio add depreciation?
Depreciation is subtracted to get EBIT but no cash leaves the business for it. Adding it back gives a rough measure of the cash available from operations to pay interest, so cash coverage is usually higher than times interest earned.