Table of Contents:

There are two important types of leverage to consider

1.  financial leverage - amount of debt that the firm must first pay back before there is any money left over for the  shareholders (debt vs. equity analysis)

2.  operating leverage - amount of fixed costs that the firm must cover in order to start making a profit (fixed costs vs. variable costs analysis). 

Both of these factors are related to the risk of a firm, and have the potential to magnify potential returns for good performance, and punish the firm for poor performance. 

Financial Leverage:

Compares the amount of debt that the firm must first pay back before there is any money left over for the  shareholders (debt vs. equity analysis).

Financial leverage tools of evaluation measure the likelihood that a company will default on their debt obligations.   If a firm adds too much debt (which they have an incentive to do because debt financing is cheaper due to tax advantages of interest being deductible), then the ratios are there to alert bankers and lenders that the firm is entering the danger zone, and that some loans might want to be called in, and further loans might be canceled.  These ratios are meant to be warning signs before bankruptcy.

Debt Ratio:  total debt/ total assets

Debt / Equity ratio:

Times Interest earned ratio (TIE):

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