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Saturday, December 4, 2010

Financial Metrics - Leverage Ratios

Leverage ratios calculate the proportionate contributions of owners and creditors to a business.  Creditors like owners to participate to secure their margin of safety, while management enjoys the greater opportunities for risk shifting and multiplying return on equity that debt offers.  Leverage can magnify earnings and it exaggerates losses.  The following are leverage ratios:
  • Equity Ratio
  • Debt to Equity Ratio
  • Debt Ratio

Equity Ratio - common stockholders' equity to total capital of the business shows how much of the total capitalization actually comes from the owners.

Common Shareholders' Equity / Total Capital Employed = Equity Ratio

Debt to Equity Ratio - a high ratio means less protection for creditors.  A low ratio indicates a wider safety margin.

(Debt+Preferred Long-Term) / Common Stockholders' Equity = Debt to Equity Ratio

Debt Ratio - what percentage of your funds are provided by creditors?  Creditors prefer a lower ratio, and management may prefer to leverage operations producing a higher ratio.

(Current + Long-Term Debt) / Total Assets = Debt Ratio

Read more about ratios at:
Financial Metrics - Ratio Analysis Considerations