Leverage Ratios: Formulas & Interpretation

Leverage ratios are critical financial metrics that measure how much of a company’s capital comes from debt versus equity. Understanding these ratios helps investors, creditors, and analysts assess a company’s financial risk and its ability to meet long-term obligations.

Whether you’re analyzing a potential investment or evaluating your own business, mastering leverage ratios is essential for sound financial decision-making. For a complete overview of all financial metrics, visit our main financial ratios hub.

What Are Leverage Ratios?

Leverage ratios (also called solvency ratios or gearing ratios) quantify the degree to which a company uses borrowed money to finance its operations. They answer a fundamental question: How much does this company rely on debt?

A highly leveraged company has more debt relative to equity, which can:

• Amplify returns when times are good
• Increase risk when revenues decline
• Limit flexibility for future borrowing

Key Leverage Ratio Formulas

1. Debt-to-Equity Ratio

The debt-to-equity ratio compares total debt to shareholders’ equity, showing how much debt a company uses for every dollar of equity.

Formula:

Debt-to-Equity Ratio = Total Debt / Shareholders' Equity

Example: If a company has $500,000 in total debt and $250,000 in shareholders’ equity:

D/E Ratio = $500,000 / $250,000 = 2.0

This means the company has $2 of debt for every $1 of equity.

Interpretation:

• < 1.0: Conservative financing, more equity than debt
• 1.0 - 2.0: Moderate leverage, common in many industries
• > 2.0: High leverage, higher financial risk

2. Debt Ratio

The debt ratio shows what percentage of a company’s total assets are financed by debt.

Formula:

Debt Ratio = Total Debt / Total Assets

Example: With $500,000 in debt and $1,000,000 in total assets:

Debt Ratio = $500,000 / $1,000,000 = 0.50 (or 50%)

This indicates that half of the company’s assets are financed by debt.

Interpretation:

• < 0.4 (40%): Low leverage, conservative approach
• 0.4 - 0.6: Moderate leverage
• > 0.6 (60%): High leverage, potential concern for creditors

3. Interest Coverage Ratio

The interest coverage ratio (also called times interest earned) measures a company’s ability to pay interest on its outstanding debt.

Formula:

Interest Coverage Ratio = EBIT / Interest Expense

Where EBIT = Earnings Before Interest and Taxes

Example: With EBIT of $200,000 and annual interest expense of $40,000:

Interest Coverage = $200,000 / $40,000 = 5.0x

This company can cover its interest payments 5 times over.

Interpretation:

• < 1.5: Danger zone—may struggle to pay interest
• 1.5 - 3.0: Adequate, but limited margin for error
• > 3.0: Comfortable coverage, lower default risk

How to Interpret Leverage Ratios

Context Matters

Leverage ratios should always be evaluated in context:

1. Industry Comparison: Capital-intensive industries (utilities, real estate) naturally carry more debt than service businesses.

2. Historical Trends: Is leverage increasing or decreasing over time? A rising debt-to-equity ratio could signal trouble—or strategic expansion.

3. Interest Rate Environment: Low interest rates make debt more affordable, potentially justifying higher leverage.

4. Business Cycle: Companies may increase leverage during expansion and reduce it during recessions.

Warning Signs

Watch for these red flags:

• Debt-to-equity ratio significantly higher than industry peers
• Declining interest coverage ratio over multiple quarters
• Debt ratio approaching or exceeding 70%
• Negative equity (liabilities exceed assets)

Industry Benchmarks

Common Mistakes to Avoid

1. Ignoring Off-Balance-Sheet Debt: Operating leases and other commitments may not appear as debt but still represent obligations.

2. Using Book Values Only: Market values can differ significantly from book values, especially for equity.

3. Comparing Across Industries: A D/E ratio of 2.0 is alarming for a tech company but normal for a utility.

4. Focusing on One Ratio: Use multiple leverage ratios together with liquidity ratios and profitability metrics for a complete picture.

Quick Reference Summary

Related Resources

• Financial Ratios Cheat Sheet — All formulas in one place
• Liquidity Ratios — Current and Quick Ratio explained
• Efficiency Ratios — Turnover and working capital metrics
• Return to Main Financial Ratios Home

Last updated: December 2025