Section: 2 Financial Ratio Analysis

Sub Section: 2 Financial Leverage Ratio

Companies make use of debt capital to finance their assets. Financial leverage refers to the degree of debt capital in the capital structure. It is believed that a certain level of debt is desirable as it can be beneficial to the business. However, presence of a debt element in the capital structure also means additional financial risk (also known as bankruptcy risk). Therefore it is important to manage the exposure to financial risk and the following ratios are useful in identifying this risk. 


Total Debt to Total Assets

This is the first broadest test to measure the proportion of total debt used in the capital structure to finance the assets. The higher the ratio, the greater the financial risk.  But this phenomena is not always true, because the asset values used to calculate this ratio are historical values, not at the current or fair market values.  Moreover, it also ignores future potential of the business and effectiveness of the assets.  However, it gives a general idea to the analyst regarding the amount of debt, and whether further investigation is needed to explore reasons for abnormality in the ratio.  The ratio is computed using the following formula:



Total Debt

Total Assets


Debt to Equity

This is the ratio of total debt, both current and long-term, and stock holder’s equity (net assets).  This ratio analyzes the relative proportion of all debt claims to ownership claims against total assets, and is used as a barometer of debt exposure.



Total Debt

Shareholders’ Equity


This ratio carries the same limitation as other debt ratios, as all the amounts are derived from the balance sheet which does not represent current fair market value nor the impact of operational performance.


Debt to Capitalization

This is more refined version of total debt to total assets ratio, involving only long-term portion of debt in invested capital.  Invested capital is the sum of long-term debt (LTD) and stockholders’ equity. 



Total Long Term Debt

Total LTD + Equity


This ratio is important in obtaining additional financing, as usually debt covenants from existing creditors provides certain limits to maintain this ratio.  This ratio also has the same limitations as other debt ratios.