Financial leverage can be aptly described as the extent to which a business or investor is using the

borrowed money. Business companies with high leverage are considered to be at risk of bankruptcy
if, in case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in
future. It is not that financial leverage is always bad. However, it can lead to an increased
shareholders’ return on investment. Also, very often, there are tax advantages related with
borrowing, also known as leverage.
Formula
The most well known financial leverage ratio is the debt-to-equity ratio (see also debt ratio, equity
ratio). It is calculated as:
Total debt / Shareholders Equity
Calculating financial leverage
Financial leverage indicates the reliability of a business on its debts in order to operate. Knowing
about the method and technique of calculating financial leverage can help you determine a business’
financial solvency and its dependency upon its borrowings. The key steps involved in the calculation
of Financial Leverage are:
 Compute the total debt owed by the company. This counts both short term as well as long term
debt, also including commodities like mortgages and money due for services provided.
 Estimate the total equity held by the shareholders in the company. This requires multiplying the
number of outstanding shares by the stock price. The total amount thus obtained represents the
shareholder equity.
 Divide the total debt by total equity. The quotient thus obtained represents the financial leverage
ratio.
Norms and Limits
If the financial leverage ratio of a company is higher than 2-to-1, it indicates financial weakness. If
the company is leveraged highly, it is considered to be near bankruptcy. Also, it might not be able to
secure new capital if it is incapable of meeting its current obligations.
The debt-to-equity ratio (debt/equity ratio, D/E) is a financial ratio indicating the relative proportion
of entity's equity and debt used to finance an entity's assets. This ratio is also known as financial
leverage.
Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a company's
financial standing. It is also a measure of a company's ability to repay its obligations. When
examining the health of a company, it is critical to pay attention to the debt/equity ratio. If the ratio is
increasing, the company is being financed by creditors rather than from its own financial sources
which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios
because their interests are better protected in the event of a business decline. Thus, companies with
high debt-to-equity ratios may not be able to attract additional lending capital.
Calculation (formula)
A debt-to-equity ratio is calculated by taking the total liabilities and dividing it by the shareholders'
equity:
 Debt-to-equity ratio = Liabilities / Equity
Both variables are shown on the balance sheet (statement of financial position).
Norms and Limits
Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is very
industry specific because it depends on the proportion of current and non-current assets. The more
non-current the assets (as in the capital-intensive industries), the more equity is required to finance
these long term investments.
For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public
companies the debt-to-equity ratio may be much more than 2, but for most small and medium
companies it is not acceptable. US companies show the average debt-to-equity ratio at about 1.5
(it's typical for other countries too).
In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough
cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also indicate that a
company is not taking advantage of the increased profits that financial leverage may bring.
Exact Formula in the ReadyRatios Analytical Software
Debt-to-equity ratio = F1[Liabilities] / F1[Equity]
F1 – Statement of financial position (IFRS)
The current ratio is balance-sheet financial performance measure of company liquidity.
The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio
measures whether or not a firm has enough resources to pay its debts over the next 12 months.
Potential creditors use this ratio in determining whether or not to make short-term loans. The current
ratio can also give a sense of the efficiency of a company's operating cycle or its ability to turn its
product into cash. The current ratio is also known as the working capital ratio.
Calculation (formula)
The current ratio is calculated by dividing current assets by current liabilities:
The current ratio = Current Assets / Current Liabilities
Both variables are shown on the balance sheet (statement of financial position).
Norms and Limits
The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a
comfortable financial position for most enterprises. Acceptable current ratios vary from industry to
industry. For most industrial companies, 1.5 may be an acceptable current ratio.
Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting
current obligations. However, an investor should also take note of a company's operating cash flow
in order to get a better sense of its liquidity. A low current ratio can often be supported by a strong
operating cash flow.
If the current ratio is too high (much more than 2), then the company may not be using its current
assets or its short-term financing facilities efficiently. This may also indicate problems in working
capital management.
All other things being equal, creditors consider a high current ratio to be better than a low current
ratio, because a high current ratio means that the company is more likely to meet its liabilities which
are due over the next 12 months.
Exact Formula in the ReadyRatios Analytic Software
Current ratio = F1[CurrentAssets]/F1[CurrentLiabilities]
F1 – Statement of financial position (IFRS).
The interest coverage ratio (ICR) is a measure of a company's ability to meet its interest payments.
Interest coverage ratio is equal to earnings before interest and taxes (EBIT) for a time period, often
one year, divided by interest expenses for the same time period. The interest coverage ratio is a
measure of the number of times a company could make the interest payments on its debt with its
EBIT. It determines how easily a company can pay interest expenses on outstanding debt.
Interest coverage ratio is also known as interest coverage, debt service ratio or debt service
coverage ratio.
Calculation (formula)
The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes
(EBIT) by the company's interest expenses for the same period.
Interest coverage ratio = EBIT / Interest expenses
Norms and Limits
The lower the interest coverage ratio, the higher the company's debt burden and the greater the
possibility of bankruptcy or default. A lower ICR means less earnings are available to meet interest
payments and that the business is more vulnerable to increases in interest rates. When a company's
interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.
An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash
necessary to pay its interest obligations (i.e. interest payments exceed its earnings (EBIT)).
A higher ratio indicates a better financial health as it means that the company is more capable to
meeting its interest obligations from operating earnings. On the other hand, a high ICR may suggest
a company is "too safe" and is neglecting opportunities to magnify earnings through leverage.
Exact formula in the ReadyRatios analytic software
Interest coverage ratio = EBIT / F2[FinanceCosts]
The receivable turnover ratio (debtors turnover ratio, accounts receivable turnover ratio) indicates
the velocity of a company's debt collection, the number of times average receivables are turned over
during a year. This ratio determines how quickly a company collects outstanding cash balances from
its customers during an accounting period. It is an important indicator of a company's financial and
operational performance and can be used to determine if a company is having difficulties collecting
sales made on credit.
Receivable turnover ratio indicates how many times, on average, account receivables are collected
during a year (sales divided by the average of accounts receivables). A popular variant of the
receivables turnover ratio is to convert it into an Average collection period in terms of days. The
average collection period (also called Days Sales Outstanding (DSO)) is the number of days, on
average, that it takes a company to collect its accounts receivables, i.e. the average number of days
required to convert receivables into cash.
An accounting measure used to quantify a firm's effectiveness in extending credit as well as
collecting debts.
Calculation (formula)
Receivables turnover ratio = Net receivable sales/ Average accounts receivables
Accounts Receivable outstanding in days:
Average collection period (Days sales outstanding) = 365 / Receivables Turnover Ratio
Norms and Limits
There is no general norm for the receivables turnover ratio, it strongly depends on the industry and
other factors. The higher the value of receivable turnover the more efficient is the management of
debtors or more liquid the debtors are, the better the company is in terms of collecting their accounts
receivables. Similarly, low debtors turnover ratio implies inefficient management of debtors or less
liquid debtors. But in some cases too high ratio can indicate that the company's credit lending
policies are too stringent, preventing prime borrowing candidates from becoming customers.
Exact formula in the ReadyRatios analytic software
Average collection period = ((F1[b][TradeAndOtherCurrentReceivables] +
F1[e][TradeAndOtherCurrentReceivables])/2)/(F2[Revenue]/NUM_DAYS)
Receivables turnover ratio = 365 / Average collection period
F2 – Statement of comprehensive income (IFRS).
F1[b], F1[e] - Statement of financial position (at the [b]eginning and at the [e]nd of the analizing
period).
NUM_DAYS – Number of days in the the analizing period.
Solvency ratio is one of the various ratios used to measure the ability of a company to meet its long
term debts. Moreover, the solvency ratio quantifies the size of a company’s after tax income, not
counting non-cash depreciation expenses, as contrasted to the total debt obligations of the firm.
Also, it provides an assessment of the likelihood of a company to continue congregating its debt
obligations.
Formula
The formula used for computing the solvency ratio is:
Solvency ratio = (After Tax Net Profit + Depreciation) / Total liabilities
As stated by Investopedia, acceptable solvency ratios vary from industry to industry. However, as a
general rule of thumb, a solvency ratio higher than 20% is considered to be financially sound.
Generally, a lower solvency ratio of a company reflects a higher probability of the company being on
default with its debt obligations.
Different forms of solvency ratios
Generally, there are six key financial ratios used to measure the solvency of a company. These
include:
 Current ratio
Computed as Current Assets ÷ Current liabilities, this ratio helps in comparing current assets to
current liabilities and is commonly used as a quantification of short-term solvency.
 Quick ratio
Also known as ‘liquid ratio’ and computed as Cash + Accounts Receivable ÷ Current liabilities,
considers only the liquid forms of current assets thus revealing the company’s reliability on inventory
and other current assets to settle short-term debts.
 Current debts to inventory ratio
Computed as Current liabilities ÷ Inventory, this ratio reveals the reliability of a company on available
inventory for the repayment of debts
 Current debts to net worth ratio
Computed as Current liabilities ÷ Net worth, this ratio indicates the amount due to creditors within a
year’s time as a percentage of the shareholders investment
 Total liabilities to net worth ratio
Computed as Total Liabilities ÷ Net Worth¸ this ratio reveals the relation between the total debts and
the owners’ equity of a company. A higher ratio indicates less protection for business’ creditors.
 Fixed assets to net worth ratio
Computed as Fixed Assets ÷ Net Worth, represents the percentage of assets centered in fixed
assets I comparison to total equity.
he receivable turnover ratio (debtors turnover ratio, accounts receivable turnover ratio) indicates
the velocity of a company's debt collection, the number of times average receivables are turned over
during a year. This ratio determines how quickly a company collects outstanding cash balances from
its customers during an accounting period. It is an important indicator of a company's financial and
operational performance and can be used to determine if a company is having difficulties collecting
sales made on credit.
Receivable turnover ratio indicates how many times, on average, account receivables are collected
during a year (sales divided by the average of accounts receivables). A popular variant of the
receivables turnover ratio is to convert it into an Average collection period in terms of days. The
average collection period (also called Days Sales Outstanding (DSO)) is the number of days, on
average, that it takes a company to collect its accounts receivables, i.e. the average number of days
required to convert receivables into cash.
An accounting measure used to quantify a firm's effectiveness in extending credit as well as
collecting debts.
Calculation (formula)
Receivables turnover ratio = Net receivable sales/ Average accounts receivables
Accounts Receivable outstanding in days:
Average collection period (Days sales outstanding) = 365 / Receivables Turnover Ratio
Norms and Limits
There is no general norm for the receivables turnover ratio, it strongly depends on the industry and
other factors. The higher the value of receivable turnover the more efficient is the management of
debtors or more liquid the debtors are, the better the company is in terms of collecting their accounts
receivables. Similarly, low debtors turnover ratio implies inefficient management of debtors or less
liquid debtors. But in some cases too high ratio can indicate that the company's credit lending
policies are too stringent, preventing prime borrowing candidates from becoming customers.
Exact formula in the ReadyRatios analytic software
Average collection period = ((F1[b][TradeAndOtherCurrentReceivables] +
F1[e][TradeAndOtherCurrentReceivables])/2)/(F2[Revenue]/NUM_DAYS)
Receivables turnover ratio = 365 / Average collection period
F2 – Statement of comprehensive income (IFRS).
F1[b], F1[e] - Statement of financial position (at the [b]eginning and at the [e]nd of the analizing
period).
NUM_DAYS – Number of days in the the analizing period.
Accounts payable turnover ratio is an accounting liquidity metric that evaluates how fast a
company pays off its creditors (suppliers). The ratio shows how many times in a given period
(typically 1 year) a company pays its average accounts payable. An accounts payable turnover ratio
measures the number of times a company pays its suppliers during a specific accounting period.
Accounts payables turnover trends can help a company assess its cash situation. Just as accounts
receivable ratios can be used to judge a company's incoming cash situation, this figure can
demonstrate how a business handles its outgoing payments.
Calculation (formula)
Accounts-payable turnover is calculated by dividing the total amount of purchases made on credit by
the average accounts-payable balance for any given period.
Accounts payable turnover ratio = Total purchases / Average accounts payable
There is no single line item that tells how much a company purchased in a year. The cost of sales in
the income statement (statement of comprehensive income) shows what was sold, but the company
may have purchased either more or less than it eventually sold. The result would be either an
increase, or a decrease in inventory. To calculate the purchases made, the cost of goods sold is
adjusted by the change in inventory as follows:
Purchases = Cost of sales + Ending inventory – Starting inventory
Again, as with the accounts receivable turnover ratios, this can be expressed in terms of a number of
days by dividing the result into 365:
Days Payable Outstanding (DPO) = 365 /Accounts payable turnover ratio
Norms and Limits
Payment requirements will usually vary from supplier to supplier, depending on its size and financial
capabilities. A high ratio means there is a relatively short time between purchase of goods and
services and payment for them. Conversely, a lower accounts payable turnover ratio usually signifies
that a company is slow in paying its suppliers.
But a high accounts payable turnover ratio is not always in the best interest of a company. Many
companies extend the period of credit turnover (i.e. lower accounts payable turnover ratios) getting
extra liquidity.
Exact Formula in the ReadyRatios Analytic Software
Days Payable Outstanding = ((F1[b][TradeAndOtherCurrentPayables] +
F1[e][TradeAndOtherCurrentPayables]+F1[b][CurrentProvisionsForEmployeeBenefits]
+F1[e][CurrentProvisionsForEmployeeBenefits])/2)/((F2[CostOfSales]+ F1[e][Inventories] -
F1[b][Inventories])/NUM_DAYS)
Accounts payable turnover ratio = 365 / Days payable outstanding
F2 – Statement of comprehensive income (IFRS).
F1[b], F1[e] - Statement of financial position (at the [b]egining and at the [e]nd of the analysed
period).
NUM_DAYS – Number of days in the the analysed period.
365 – Days in year.
Note: Employee benefits are considered here as a part of purchases because they are also account
payables and also form cost of sales.