Leverage Ratios in Financial Analysis

Abstract

This note introduces multiple concepts of leverage from an accounting context, specifically as they relate to balance sheets and income statements. Both operating- and financial-leverage ratios and their relation to changes in widely accepted profitability measures are reviewed. Excerpt UVA-C-2291 Dec. 1, 2014 Leverage Ratios in Financial Analysis In a business context, “leverage” relates to the degree to which an entity employs its assets, liabilities, and fixed-cost mix to achieve increased returns. A balance of risk is involved with increasing leverage because any benefits achieved can often quickly reverse. Understanding the fundamental definitions, calculations, and principles of leverage s critical to analyzing a business and its investment opportunities. This note introduces multiple concepts of leverage from an accounting context, specifically as they relate to balance sheets and income statements. Both operating- and financial-leverage ratios and their relation to changes in widely accepted profitability measures are reviewed. Leverage on the Balance Sheet Arguably the most common view of leverage relates to how much a firm's assets are encumbered by debt, often labeled balance sheet leverage. The manager's motivation for balance sheet leverage is straightforward: Borrowed capital increases the return to stock investors if the company can deploy that borrowed capital in investments that yield greater returns than the cost of debt. Balance sheet leverage can be characterized in ratio form as: . . .