Leverage refers to the ability to lift a heavier load using a fulcrum and a lever. The common image is a board on a triangular pivot point with a heavy weight (M1) on one end and a lighter weight (M2) on the other. As the lever shifts towards the lighter load it starts to lift the heavier weight. In effect, as the distance ‘b’ gets longer, it becomes easier to lift M1. This principle works with finances too. How so?
Leverage ratios evaluate the lower half of the balance sheet. Its primary purpose is the analyzes debt in comparison to equity or the profitability of the business.
Ratios are used in business to compare companies of different sizes within the same industry. The goal is to discover the best investment for return on your stock purchase. Business ratios essentially equalize different size companies within the same industry. A common mistake is to compare two different industries within the same sector (explained below).
Another leverage ratio used to evaluate the financial integrity of a business is the debt to equity ratio. It is strictly a bottom half balance sheet ratio. Its result explains the relationship of volume of debt and corresponding equity to finance the operations of a business, i.e. the purchase of assets.