The financial leverage ratio is a metric that assesses a company’s reliance on debt financing by comparing its debt to its equity or assets.
Primary Implication
A lower Financial Leverage Ratio indicates the owners have used more of their equity than debt to finance the purchase of company assets.
A high ratio means the company uses debt and other liabilities to finance its assets. This does not present a problem until revenues and profits decrease, making it difficult to meet the debt obligations tied to financed assets.
Be sure you know you can afford the cost of the debt before you enter into a monthly payment plan to buy a new asset.
Overview
The Financial Leverage Ratio is a Coverage Ratio that reflects the relationship between debt and equity on the right-hand side of a company’s Balance Sheet. It measures how much in assets a company holds, relative to its equity, by calculating how much debt the firm has accrued to acquire its assets.
The inverse of this ratio is “Debt to Equity,” which shows that increasing leverage means increasing the proportion of debt to service, relative to equity.
A company must earn enough income to cover its interest expense and generate sufficient cash flow to meet the required interest and principal payments. Failing to do so can result in insolvency, financial distress, and bankruptcy.
The formula for calculating the Financial Leverage Ratio is as follows:
Total Assets / Owners’ Equity
A ratio of 1 or less means that the owners own all of the business assets. A ratio of 2-to-1 indicates that half of the assets were purchased through equity and the other half through financing.
Lower is Better: owners have used more of their equity than debt when financing company assets.
Higher is Worse: means that the company is using debt and other liabilities to finance its assets.