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.
What you will learn
- 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
The formulas
- 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
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).
Common 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.