The process of magnifying the shareholders’ return through the employment of debt is called “Financial Leverage” or “Trading on Equity”. These ratios are called as financial ratios also. Leverage Ratios which are used to ascertain long-term solvency of a firm have two aspects:
A. Debt Repaying capacity measured through Structural Ratios
B. Interest paying capacity measured through Coverage Ratios
a. Structural Ratios
These ratios examine the soundness of the capital structure
a. Debt-Equity Ratio
This ratio indicates the relative proportions of debt and equity in financing & claims against the assets of the firm.
D/E Ratio =Debt or Total Debt or Outsiders Funds or External Equities/ Equity Shareholders’ Equity or Net Worth or Internal Equities
The Debt Equity Ratio may relate only Long-term debt, in which case the formula is as below:
D/E Ratio =Long-term Debt/Shareholders’ Equity
b. Debt to Total Assets
The Proportion of the assets that are financed with debt is
indicated by this ratio
c. Debt to Capitalization Ratio
This is a link between the outsiders long-term debt and long-term funds in the firm.
Debt Total /Capital Employed Net Assets(Total Debt + Net Worth) (Total Assets – Current Liabilities)
d. Proprietary Ratio
The Proportion of Total Assets financed by owners is indicated by this ratio.
Net Worth/Total Assets
e. Capital Gearing Ratio
Net Worth/Fixed income bearing funds(debentures, preference capital, loans)