“When you combine ignorance and leverage, you get some pretty interesting results.” – Warren Buffett
What are leverage ratios?
Measures a business’s reliance on debt and equity, risk related to its debt obligations, and the efficient (or inefficient) use of debt.
Why do I need to understand leverage ratios?
Small business owners should understand the capital structure of their business’s and whether their use of debt effective. Lenders use leverage ratios when making decisions about whether or not extend credit or loans since they are an indication of a business’s ability to pay debts as they come due. Knowing what your small business’s leverage ratios before approaching a lender will help you understand, first whether they would extend credit in the first place and second illustrate to the lender that you are a savvy entrepreneur.
What are the different types of leverage ratios?
Debt ratio – Measures the use of debt to finance a company
Equity ratio – Measures the use of equity to finance a company
Debt-to-equity ratio – Measures the use of debt and owner funds to finance a company
Equity multiplier – Measures how much of a business’s assets are financed by the owner
Interest coverage ratio – Measures a business’s ability to use debt effectively
Debt service coverage – Measures a business’s ability to use cash flows to debt
Do you know what your business’s leverage ratios are?
Leverage ratios provide insights into a business’s ability to pay debts and effectively use debt to finance operations. Knowing what yours are now can help you determine whether or not it is a good time to apply for a loan or line of credit or wait so that you can take steps to better position the business for the future.