What are Financial Leverage Ratios?

Computech has been in business for over 20 years. They have

tried to remain current on their product offerings and invest in
research and development. However, competitors are
outperforming Computech's sales, and the executives would like
to request a $1 million business loan for new inventory,
advertising and marketing.
The chief financial officer, Mark, applies for a business loan at
Bank and Trust. The loan officer reviews Computech's financial
information and tells Mark the company is highly leveraged.
The loan officer explains that leverage is a ratio of the
company's debt and equity.
Highly leveraged means that the company has taken on too
many loans and is in too much debt. He goes on to say there are
three financial leverage ratios the bank reviewed to determine
the decision: debt ratio, debt-to-equity ratio and interest
coverage ratio.
Financial leverage ratios compare how much debt a company
has incurred in relation to assets, equity and interest. When
companies want to expand, grow or invest in research and
development, they have two main options: finance these
initiatives with debt (loans from the bank) or equity (cash from
selling stock to the public).
We'll focus on Computech's use of loans first by calculating the
debt ratio.
The debt ratio shows how well a company can pay their
liabilities with their assets. Before further explaining the debt
ratio, let's define liabilities and assets. Liabilities are obligations
a company owes, such as a loan to purchase computer
inventory. Assets are items owned by the company, such as the
actual inventory. So, the debt ratio essentially tells us what
percentage of the total assets are owed in loans.
To calculate the debt ratio we take total liabilities divided by
total assets. \
If Computech has total assets of $25,000 and total liabilities of
$17,500 ($17,500/$25,000), their debt ratio is 70%.
This means Computech owns less of their assets than they owe.
Banks like to see a debt ratio of 40% or less. They are interested
in the company owning more of their assets possibly to use as
collateral for a new loan.

emember another way a company can finance their expansion,

growth, research and development initiatives is to sell stock to
the public. This is known as equity financing. The debt-to-
equity ratio shows the percentage of financing that comes from
banks or stockholders.
To calculate the debt-to-equity ratio, we take total liabilities
divided by total equity. If Computech has total liabilities of
$17,500 and total equity of $9,500 ($17,500/$9,500), their debt-
to-equity ratio is 1.84.
The debt-to-equity ratio is a baseline ratio, meaning there is a
minimum standard. If the ratio equals 1, Computech has equally
financed their assets with debt and equity. If the ratio is lower
than 1, Computech is financed more by stockholders or equity.
If the ratio is higher than 1, Computech is financed more with
debt. Since 1.84 is greater than 1, we can assume computech is
financed more with loan from a bank. Hence , another reason
why the loan officer denied their loan request.