Leverage and Coverage Ratios

Leverage and Coverage ratios are important when determining how much debt you can take out.

Leverage Ratio

A measure of a company’s debt levels relative to equity or assets, indicating financial risk and solvency.

Example

Let’s say that we own a flower shop. The value of our equity is $100 and we just took on a loan worth $400.

An example of a leverage ratio we could calculate here is the Debt-to-Equity Ratio.

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

Debt-to-Equity Ratio = $400 / $100

Debt-to-Equity Ratio = 4.0x

Coverage Ratio

A measure of a company’s ability to meet interest and debt obligations, or cover their debt.

Example

Let’s say we own that same flower shop. Our EBIT is $10 and our Interest Expense is $2.

An example of a coverage ratio we could calculate here is the Interest Coverage Ratio.

Interest Coverage Ratio = EBIT / Interest Expense

Interest Coverage Ratio = $10 / $2

Interest Coverage Ratio = 5.0x