Leverage and Debt Ratios#

Leverage ratios measure how much debt a company uses to finance its operations. While debt can amplify returns, it also amplifies risk. Understanding a company's leverage is essential for assessing long-term financial stability.

Leverage refers to the use of debt to finance assets. Higher leverage means more debt relative to equity, which amplifies both gains and losses.

Debt-to-Equity Ratio#

The debt-to-equity ratio is the most common measure of financial leverage, showing the relationship between debt and shareholder equity.

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

A D/E of 1.0 means equal parts debt and equity financing. Higher ratios indicate more aggressive use of leverage.

Interpreting D/E Ratio#

D/E Range	Interpretation
0 - 0.5	Conservative—mostly equity financed
0.5 - 1.0	Moderate leverage
1.0 - 2.0	Significant leverage
> 2.0	High leverage—elevated risk

Example Calculation#

Item	Amount
Short-term Debt	$50M
Long-term Debt	$200M
Total Debt	$250M
Shareholders' Equity	$500M
D/E Ratio	0.5

This company has $0.50 of debt for every $1 of equity—moderate, conservative leverage.

Industry Context#

Industry	Typical D/E	Why
Technology	0.1 - 0.5	Asset-light, cash-rich
Consumer Goods	0.5 - 1.5	Stable cash flows support debt
Utilities	1.0 - 2.0	Regulated, predictable
Banks	8 - 15	Leverage is the business model
REITs	0.5 - 1.5	Tax-efficient debt use
Airlines	1.5 - 4.0	Capital intensive, cyclical

Bank Exception

Banks naturally have very high D/E ratios (10x or more) because deposits are liabilities. Don't compare bank D/E to non-financial companies.

Debt-to-Assets Ratio#

The debt-to-assets ratio shows what percentage of a company's assets are financed by debt.

Debt-to-Assets = Total Debt / Total Assets

A ratio of 0.4 means 40% of assets are debt-financed; 60% are equity-financed.

Interpreting D/A Ratio#

D/A Range	Interpretation
< 30%	Low leverage—mostly equity financed
30 - 50%	Moderate leverage
50 - 70%	High leverage
> 70%	Very high leverage—significant risk

D/E vs. D/A Comparison#

Metric	What It Shows
Debt-to-Equity	Debt relative to shareholder investment
Debt-to-Assets	Debt relative to total resources

Both are valid; D/E is more common in equity analysis, while D/A is often used in credit analysis.

Understanding Capital Structure#

Capital structure refers to the mix of debt and equity used to finance a company. There's no "correct" structure—it depends on business characteristics.

When High Leverage Makes Sense#

Condition	Why Debt Works
Stable, predictable cash flows	Can reliably service debt
Asset-rich businesses	Collateral for secured borrowing
Tax shield benefits	Interest is tax-deductible
Low interest rate environment	Cheap borrowing costs
Mature industries	Less volatility, lower risk

When Low Leverage Is Wise#

Condition	Why Equity Preferred
Volatile cash flows	Debt payments require certainty
High growth phase	Flexibility for investment
Cyclical industries	Need buffer for downturns
High business risk	Don't add financial risk
Uncertain environment	Preserve optionality

Leverage Trade-off

Debt provides tax benefits and can boost ROE, but increases bankruptcy risk and reduces flexibility. The optimal level balances these factors based on business risk.

Good Debt vs. Dangerous Debt#

Not all debt is equal. Analyze the type and terms of debt, not just the total amount.

Characteristics of "Good" Debt#

Factor	Good Debt	Dangerous Debt
Purpose	Funds productive assets	Covers operating losses
Cost	Low interest rate	High interest rate
Maturity	Long-term, staggered	Short-term, concentrated
Currency	Matches revenue currency	Currency mismatch
Covenants	Reasonable headroom	Tight, at-risk of breach
Collateral	Minimal or none	Assets pledged

Debt Maturity Analysis#

Maturity Schedule	Assessment
Well-staggered over 10+ years	Low refinancing risk
Concentrated in 1-2 years	Refinancing pressure
Large "maturity wall" approaching	Potential stress

Example: Good vs. Bad Debt#

Company A (Good):

D/E: 0.8
Average interest rate: 4%
Maturities spread over 10 years
Funds profitable expansion

Company B (Dangerous):

D/E: 0.8
Average interest rate: 8%
$500M due in 18 months
Funds ongoing losses

Same D/E ratio, vastly different risk profiles.

Trend Analysis#

Warning Patterns#

Trend	Concern
Rapidly rising D/E	Taking on debt faster than growing equity
Debt rising, EBITDA flat	Leverage increasing without business growth
Interest rate rising on debt	Increased cost burden
Covenant cushions shrinking	Risk of technical default

Healthy Patterns#

Trend	Positive Sign
Stable or declining D/E	Deleveraging or equity growth
Debt rising with EBITDA	Proportional, productive leverage
Refinancing at lower rates	Improved financial flexibility
Extending maturities	Reduced refinancing risk

Key Takeaways

Debt-to-Equity = Total Debt / Equity—most common leverage measure
Conservative D/E: 0-0.5; High leverage: above 2.0 (except banks)
Debt-to-Assets shows percentage of assets financed by debt
Industry context is critical—utilities at 1.5x D/E is normal; tech at 1.5x is high
"Good" debt: low cost, long maturity, funds productive assets
"Dangerous" debt: high cost, short maturity, covers losses
Track trends: rising debt without earnings growth is a red flag
Banks have D/E of 10x+ by design—don't compare to non-financials