Leverage Ratio Explained: Formula, Calculation & Types

Leverage ratios illustrate the extent of a company’s borrowing in relation to its assets, equity, or earnings. Leverage ratios highlight whether a company finances its operations using debt capital (borrowed) or owners’ capital (self-financing).

For example, if you buy a $500,000 house with a $400,000 mortgage and a $100,000 down payment, then your debt-to-equity ratio is 4 to 1 ($400,000 / $100,000). The greater the ratio, the more “leveraged” you are.

Why It’s Important to Know

Leverage ratios are essential financial metrics that can provide valuable insights into a company’s financial health and risk. Here are a few reasons why they’re important:

• For Investors: Investors often use leverage ratios as a simple shortcut to get a sense of whether it is a risky proposition to invest in a particular company. The higher expected return is because of leverage, the higher the probability of default (being unable to repay the debt).
• For Lenders and Creditors: Lenders will often be the group most interested in leverage ratios, as their interests are often at the highest risk if a company fails. Lenders use leverage as one of the main determinants of whether or not to approve a loan, and what interest rate to charge. The lower the leverage, the greater the odds of approval with more favorable terms, while the more leveraged a company is, the higher the interest rates charged by lenders, or the less likely the company will be able to borrow at all.
• For Management Teams: A company’s management team may also choose to keep a very close eye on leverage ratios as a key metric in their decisions around growth. For example, if a company is too highly leveraged, it may need to be more conservative with growth or look for other ways to raise capital.
• For Analysts and Rating Agencies: Rating agencies such as Moody’s or S&P include leverage ratios in their calculations when determining how risky it might be to purchase one of a company’s bonds, or how likely the company is to default on its obligations. The credit rating assigned to the company then determines the cost of borrowing, as well as the general perception in the market.
• For Suppliers and Customers: Suppliers want to be sure that their customers can pay their invoices while customers, on the other hand, will likely take an interest in whether their suppliers are financially healthy and in a good position to provide ongoing support.

The 2008 Financial crisis is a good example of the importance of keeping leverage ratios in check. Many firms appeared to be healthy but then collapsed due to their high leverage and inability to repay their debts. Those that had more conservative leverage ratios had a greater survival rate.

Types of Leverage Ratios

There are three types of leverage analysis, each considering a different area of business. Each type considers how leverage magnifies business performance—through operating decisions, financing decisions, or both, offering insight into the overall use of fixed financing, such as debt and fixed costs, and the efficiency of doing so to generate returns.

Operating Leverage

Operating leverage is the percentage of fixed cost in a company’s overall cost structure, compared to variables costs. The following formula will show how sensitive a company’s operating income (earnings before interest and taxes, or EBIT) is to a change in sales volume.

Formula: Operating Leverage = Fixed Costs / Variable Costs

• High ratio (>50%): Indicates significant operating leverage and capital-intensive operations. These companies have substantial fixed costs like rent, equipment, and salaries that don’t change with production levels.
• Low ratio (<20%): Shows little operating leverage, typically seen in service businesses or companies with flexible cost structures.

Here, we look at how sales volume changes may impact earnings.

Financial Leverage

Financial leverage is the amount of debt or borrowed capital a company is using to fund its operations and growth, as opposed to equity financing. It is the most commonly used and discussed form of leverage in financial analysis.

• Benefits: Properly managed financial leverage can have a dramatically positive impact on ROE and EPS. This benefit occurs when a given company earns a higher return on the borrowed funds as compared to the interest costs, and those excess returns in turn flow to shareholders.
• Risks: On the flip side, high financial leverage greatly increases the risk of default and bankruptcy. In contrast to dividends to shareholders, debt payments must be made no matter how the business is performing, creating significant cash flow pressure in bad times.

Combined Leverage

Combined leverage is the sum total of operating leverage and financial leverage and (interestingly) is most often not calculated or reported.

• Analysis: Will be the combination of the leverage effects of both the upper (operating leverage feeding into operating income) and lower (financial leverage feeding into net income and EPS) halves of the income statement.
• Assessment: Pure indication of the overall impact on earnings per share available to stockholders. If a company has both high operating leverage and high financial leverage, it means that small percentage changes in sales volume will have an amplified effect on the company’s per-share earnings.

Balance Sheet Ratios

Balance sheet leverage ratios examine the static capital structure of a company by analyzing the relationship between debt, equity, and total assets at a specific point in time. These ratios reveal how a company has chosen to finance its operations and growth, providing stakeholders with insight into the fundamental financing strategy and the relative claims of creditors versus shareholders on company assets.

Debt-to-Assets Ratio

Formula: Debts-to-Assets Ratio = Total Debt / Total Assets

This ratio can tell us how much of the company’s assets have been funded by debt. It highlights the basic financing strategy employed by the company and shows how much could be at risk if something were to go wrong.

• Ratios > 60% show very aggressive debt usage, which may be concerning for many stakeholders.
• Ratios < 20% indicate conservative financing that is likely missing an opportunity to take advantage of debt’s tax benefits.
• Most healthy companies maintain ratios between 30-50%.

Example: $2M / $5M = 0.40 or 40%

This 40% ratio is right in line with industry norms for a balanced approach to financing that is not too heavily weighted towards debt.

Debt-to-Equity Ratio (D/E)

Formula: Debt-to-Equity Ratio = Total Debt ÷ Total Equity

The debt-to-equity ratio, sometimes called D/E for short, is the most commonly cited leverage ratio in financial analysis. Why? Because it shows the balance of creditor financing vs. shareholder financing in very simple terms, making it an essential ratio to know for investment and lending decisions.

• Ratios <0.5 are very conservative and could be considered low.
• Ratios 0.5-1.5 show moderate leverage.
• Ratios > 2.0 are considered high by most analysts, and may be a concern to lenders and investors.

Example: $2M / $2.5M = 0.80 or 80%. 

This 0.80 ratio indicates moderate leverage with equity holders having invested more than creditors.

Debt-to-Capital Ratio

Formula: Debt-to-Capital Ratio = Total Debt / (Total Debt + Total Equity)

This ratio provides a comparison of debt with capital, showing the percentage of total capitalization, and caps at 100%, which means this will be a more intuitive, percentage-based view of the capital structure as compared to the traditional debt-to-equity ratio.

• Most healthy companies maintain this ratio between 20-50%.
• Higher levels potentially indicate financial stress.
• Lower levels may suggest overly conservative financing.

Example: $2M / ($2M + $2.5M) = 0.44 or 44%

This 44% ratio shows debt represents a reasonable portion of the company’s total capital structure.

Asset-to-Equity Ratio (Equity Multiplier)

Formula: Asset-to-Equity Ratio = Total Assets / Total Equity

The asset-to-equity ratio shows how many times the company’s assets exceed its equity base, and can be directly linked to return on equity (ROE) in DuPont analysis. It shows the degree of financial leverage, and how a company is using debt to create greater returns to shareholders.

• As a general rule, conservative companies will maintain ratios < 3x.
• Highly leveraged companies or banks may have ratios 10x or higher.
• Most industrial companies will have operating leverage between 2-5x.

Example: $5M / $2.5M = 2.0x

This 2.0x ratio indicates moderate leverage with assets 2x greater than its equity base.

Net Debt-to-Total Capitalization

Formula: Net Debt-to-Total Capitalization = (Total Debt – Cash) / (Total Debt + Total Equity – Cash)

This ratio is significant because it recognizes that firms with large cash holdings may look overleveraged in traditional metrics until the cash is subtracted from their overall debt burden.

• This ratio provides a more accurate assessment than gross debt ratios.
• Same benchmarks apply but this will often show improved leverage positions for cash-rich companies.

Example: With $300K cash: ($2M – $300K) / ($2M + $2.5M – $300K) = 0.40 or 40%

This 40% net ratio shows improved leverage compared to the 44% gross ratio when available cash is considered.

Cash Flow Leverage Ratios

Balance sheet ratios indicate the financial structure of a company, whereas cash flow leverage ratios indicate the financial performance of a company in terms of its ability to meet its debt obligations with operating earnings. By tying debt to cash flow, cash flow leverage ratios offer the most realistic measure of a company’s ability to service its borrowings and the time required to extinguish those borrowings at current earning levels.

Total Debt-to-EBITDA Ratio

Formula: Total Debt-to-EBITDA Ratio = Total Debt / EBITDA

Total debt-to-EBITDA ratio will show how many years of current earnings would be needed to pay off all debt,  serving as the gold standard leverage ratio in financial analysis. Here debt levels are directly connected to cash-generating ability, making it the primary metric used by lenders, rating agencies, and investors to assess leverage.

• Investment-grade companies typically maintain ratios < 3x
• Ratios of 4-6x indicate higher risk levels
• Ratios above 6x often signal financial distress.

Example: $2M / $500K = 4.0x

This 4.0x ratio indicates moderate to high leverage that would benefit from improvement if possible to a scenario where the ratio is 2.0x or less.

Senior Debt-to-EBITDA Ratio

Formula: Senior Debt-to-EBITDA Ratio = Senior Debt / EBITDA

Senior debt-to-EBITDA is the same as the prior ratio but specifically focuses on senior debt. Why? Because it is most commonly used by senior lenders, who require these ratios to be well in the safe zone as part of covenant compliance. Note that lenders are typically more conservative in these limits, even though they get priority in a bankruptcy scenario.

• Senior lenders typically require ratios < 3.5x
• Many lenders maintain tighter limits of 2.5-3.0x depending on industry and company stability.

Example: If $1.5M of our $2M debt is senior: $1.5M / $500K = 3.0x

This 3.0x senior debt ratio is right at the upper end of what is acceptable to most senior lenders.

Net Debt-to-EBITDA Ratio

Formula: Net Debt-to-EBITDA Ratio = (Total Debt – Cash & Equivalents) / EBITDA

Net debt-to-EBITDA provides an even more accurate measure of leverage because it accounts for cash or equivalents on the balance sheet, which immediately reduces effective debt obligations. Most analysts and sophisticated investors recognize that firms with excess cash have much greater financial flexibility. This number will often look much improved vs. traditional debt metrics, but the same guidelines discussed for gross debt-to-EBITDA should apply.

• Often shows improved leverage positions compared to gross debt metrics.
• Same general benchmark ranges apply but are adjusted up or down depending on the liquidity position of the company.

Example: Using $300K cash: ($2M – $300K) / $500K = 3.4x

This 3.4x net ratio is significantly improved as compared to the 4.0x gross ratio, a meaningful difference if you are an analyst, investor, or lender trying to assess the risk in the company.

Debt-to-EBIT Ratio

Formula: Debt-to-EBIT Ratio = Total Debt / EBIT

This ratio is similar to the total debt-to-EBITDA ratio but uses operating income as the denominator instead. It gives a more conservative view of a company’s ability to service its debt, since EBIT excludes non-cash items like depreciation.

• EBIT-based ratios run higher than EBITDA ratios and should be evaluated with correspondingly higher benchmarks, typically 1.5-2.0x higher than equivalent EBITDA ratios.

Example: If EBIT is $300K: ($500K EBITDA – $200K depreciation): $2M /$300K = 6.7x.

The resulting 6.7x ratio will look much higher, as we’re now using the more conservative EBIT denominator.

Debt-to-EBITDA (Less CapEx) Ratio

Formula: Debt-to-EBITDA (Less CapEx) Ratio = Total Debt ÷ (EBITDA – Capital Expenditures)

The debt-to-EBITDA (less CapEx) ratio accounts for required capital investments that lower free cash flow available for debt payments. You’ll get a more realistic sense of your debt coverage when capital spending is significant and non-discretionary, as in capital-intensive industries where CapEx is necessary to sustain growth.

• Ratio typically shows higher leverage than standard EBITDA ratios.
• Particularly useful for capital-intensive industries such as manufacturing, utilities, etc.

Example: If annual CapEx is $150K: $2M ÷ ($500K – $150K) = 5.7x

This will result in a much lower 5.7x ratio, as the required capital reinvestment has a major impact on debt coverage.

Coverage Ratios

Coverage ratios examine a company’s ability to pay its current financial obligations. As such, these ratios measure whether current earnings are adequate to cover debt payments and other fixed charges. While leverage ratios indicate the proportion of debt relative to assets or equity, coverage ratios provide the more important answer to the question of how much debt the company has: can it afford to pay based on current performance?

Interest Coverage Ratio (Times Interest Earned)

Formula: Interest Coverage Ratio = EBIT / Interest Expense

Interest coverage ratio indicates how many times a company can pay interest charges. Interest expense has to be covered for a company to avoid financial distress, default, and bankruptcy. This ratio is one of the key credit rating triggers watched by the rating agencies and lenders.

• Ratios < 2.0x might not be sufficient to cover interest payments.
• Ratios of 2.0-5.0x are considered adequate.
• Ratios > 5.0x are considered strong.

Example: If annual interest is $120K: $300K EBIT / $120K = 2.5x

This 2.5x coverage indicates adequate but not strong ability to service interest payments.

Fixed Charge Coverage Ratio

Formula: Fixed Charge Coverage Ratio = (EBIT + Fixed Charges) / (Interest Expense + Fixed Charges)

This is similar to the Interest Coverage Ratio, but it also includes all other fixed payments a company must make each year. This is a more complete test of a company’s ability to make fixed payments since most businesses have more fixed obligations beyond interest expense alone, such as lease payments, preferred dividends, membership fees, and others.

• Typically runs lower than interest coverage ratios due to additional fixed obligations,
• Ratios > 1.5x considered adequate
• Ratios > 2.5x indicate strong coverage

Example: With $50K in lease payments: ($300K + $50K) / ($120K + $50K) = 2.1x

This 2.1x ratio shows adequate coverage of all fixed charges, though lower than interest-only coverage.

Debt Service Coverage Ratio

Formula: Debt Service Coverage Ratio = Net Operating Income / Total Debt Service

Debt service coverage ratio measures a company’s ability to make principal and interest payments. The ratio is an indicator of the true long-term debt-paying ability of an entity and is usually a loan covenant trigger if the coverage ratio declines too low (typically below 1.25x or so). This is because it factors in amortization of principal payments while most other debt coverage tests only include interest expense.

• Ratios < 1.25x often trigger covenant violations
• Ratios of 1.25-2.0x indicate adequate coverage
• Ratios > 2.0x show strong debt service capacity.

Example: If total debt service is $200K annually: $300K / $200K = 1.5x

This will result in an adequate 1.5x ratio here, which suggests the company can just about service its total debt.

What is a Good Leverage Ratio?

While there’s no single answer, a good leverage ratio is always within your industry norms. That said, different sectors have dramatically different standards so it’s vital to understand what’s “normal” and why it might change. A ratio that’s dangerously high for an industrial manufacturer could be very low for a software company. In addition to industry, company-specific factors can also alter the acceptable leverage level. Signs of trouble include quickly rising leverage multiples, breaching industry medians, falling interest coverage, and breaching debt covenants..

Industry Benchmarks (Debt-to-EBITDA)

The debt-to-EBITDA ratio varies dramatically across sectors due to fundamental business model differences. Utilities sustain higher leverage multiples because their cash flows are predictable and regulated, while technology firms face earnings volatility that demands conservative debt levels. A 3.0x ratio carries vastly different risk implications for a utility versus a tech company. These industry benchmarks reflect sector-specific realities, while the general leverage guidelines provide universal risk classifications. Understanding both frameworks is essential for accurate financial analysis, as generic leverage guidelines can mislead stakeholders about actual financial risk in different industries.

General Leverage Guidelines

Industry benchmarks vary widely, reflecting industry standards. The leverage categories below are designed as a broad-based guide for all companies and industries. These categories are based on the risk level associated with a given amount of debt relative to EBITDA, regardless of the industry. For example, a highly “Conservative” level of leverage suggests the lowest risk of default. Companies with leverage above 6.0x are considered “Distressed,” and default or bankruptcy is likely.

Warning Signs

Beware when you start seeing several of the following signs together, and even more so if they’re getting worse over multiple quarters. This can quickly become a snowball where one metric triggers another and very quickly leads to severe consequences. Some of the most important warning signs to watch for include:

• Rapidly increasing leverage ratios can be a problem, especially when it grows faster than earnings, or if caused by highly-leveraged acquisitions that don’t meaningfully increase cash flow.
• Ratios significantly above your industry median may be cause for concern as overleveraged companies start to run into higher default risks and competitive disadvantages.
• Declining coverage ratios are also an early warning of a possible problem where earnings are starting to fall short of servicing debt levels over several quarters.
• Covenant violations or even approaching a covenant trigger are troubled signs that can quickly lead to accelerated repayments and additional operational restrictions.

These are all early warning signs so there’s typically time to react if you’re paying attention.