Leverage ratio explained: understanding the definition
Leverage Ratio Definition
A leverage ratio measures the extent to which a business is financed through debt relative to equity, assets, or earnings. CFOs closely monitor leverage ratios to understand financial risk, ensure compliance with lender covenants, and guide capital structure decisions. Common leverage ratios include debt-to-equity, debt-to-assets, and debt-to-EBITDA. Higher leverage can amplify returns during growth but increases vulnerability during downturns. Maintaining the right balance is crucial for optimizing the cost of capital, preserving credit ratings, and sustaining long-term financial flexibility.
How Leverage Ratios Work
Leverage ratios are calculated by comparing total debt with other key financial metrics, such as equity, total assets, or EBITDA (earnings before interest, taxes, depreciation, and amortization). The most widely used ratios are:
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Debt-to-equity ratio: Total debt divided by shareholders’ equity.
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Debt-to-assets ratio: Total debt divided by total assets.
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Debt-to-EBITDA ratio: Total debt divided by EBITDA, measuring how many years of earnings would be needed to pay off debt.
These ratios provide insight into how aggressively a company is using borrowed funds to finance growth or operations.
Why Leverage Ratios Matter
For US mid-market companies, leverage ratios are vital benchmarks for financial health and risk management. They help CFOs ensure the organization does not breach loan covenants, maintain optimal borrowing capacity, and control the cost of capital. Creditors and investors also use leverage ratios to assess a company’s default risk, creditworthiness, and overall financial resilience in both growth cycles and downturns.
Examples and Use Cases
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Bank loan agreements: Lenders may require the business to stay below a maximum leverage ratio as part of a covenant.
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Capital planning: CFOs use leverage ratios to decide on funding sources for acquisitions or expansion.
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Credit rating reviews: Agencies evaluate leverage when assigning or updating company credit ratings.
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Board reporting: Finance teams track and present leverage metrics to demonstrate prudent capital management.
Conclusion
Leverage ratios are key indicators of indebtedness and financial strategy for mid-market organizations. Maintaining healthy leverage supports stability, funding flexibility, and sustainable growth—while excessive leverage raises costs and exposes the company to greater financial strain in challenging markets.
Read Also
What is a leverage ratio, and how to calculate it
How leverage is used to improve a company's cash flow
Why is financial leverage so important for businesses?
