Leverage Ratio Analysis

Leverage is wonderful  technique which is used in physics, maths, business and finance area of education. In physics, big weight is picked up with small iron stick through at good position and good angle of picking up. It is also used in finance. In finance, leverage is used for solving money problem by taking more and more debt and earning big money.


Through better understanding and analysis of leverage ratio, it is possible. Leverage ratio is debt-equity ratio. But in the analysis of leverage ratio, we also analysis of our return on investment and interest rate on debt in financial market.

First of all understand Leverage Ratio :

Formula of leverage ratio = Total Debt / Total Equity Capital

In total debt, we add long term and short term loan which is taken on any fixed rate of interest.


As per industry rule

As per industry rule, debt equity ratio must be low as possible. For example, if you have 1 : 10, it is good debt equity or leverage ratio. It means, you have own capital is 10$ and you have already taken $ 1. So, you can get any next $ 1 in the form of industry anytime. Because you are more secure. If you have debt equity ratio is $ 10 : $ 1, your business is so risky. Because if today, your all assets will count, you will become insolvent. Because every creditor will get only 1/10 part of his debt.

But you have to go above from this by analysis it will rate of return on investment and interest rate on loan in the market. There two biggest mistake in taking more debt by companies. Lots of finance managers, only check leverage ratio. They do not go next step of analysis it with rate of return on investment and rate interest on the loan in market. Following are two biggest mistakes.

1st Biggest Mistake :  High Leverage Ratio if Rate of interest on debt is higher than rate of return on investment


If any company is taking big loan when its rate of return from business investment is less than rate of interest on loan because at that time cost of debt will be higher than earning on the utilization of debt. So, in same situation, company starts to stop to take debt and should start to repay loan fast as possible.


2nd Biggest Mistake : Low Leverage Ratio if Rate of Interest on Debt is less than rate of return on investment

If you are earning income from your business and your rate of return is much higher than rate of interest on debt, you can take the benefit from your leverage. For this, you just increase your debt because it is so cheap. If you did not take this, you will not get another opportunity.

{ It is just science of finance. But As per my personal personal philosophy, debt is like the game of gambling. Whether, he or she or company is taking loan at cheap rate. But, due to this habit, he or she or company will become helpless. When it will higher than rate of return, still he or she or company will take the debt and start to doing first mistake. So, better is debt should zero all the time. }