What does the leverage ratio measure, and why is high leverage risky?

What does the leverage ratio measure, and why is high leverage risky?

• A. It measures liquidity; high leverage improves cash flow.
• B. It measures debt relative to equity or assets; high leverage indicates greater fixed financing costs and default risk.
• C. It measures profitability; high leverage increases ROE.
• D. It is a measure of market risk; high leverage reduces interest expenses.

Answer: (B)

The leverage ratio shows how much a company’s funding comes from debt relative to its equity or to its assets. When leverage is high, a larger portion of financing is fixed costs, like interest payments, that must be covered no matter how sales or earnings look. If business conditions worsen, those fixed obligations can strain cash flow, increasing the likelihood of default or distress and reducing financial flexibility. That combination—more debt with fixed costs and greater risk if earnings falter—is why high leverage is considered risky. It’s not primarily a liquidity measure (that looks at short-term obligations), nor a direct measure of profitability, and it doesn’t reflect market risk or reduce interest expenses.

The leverage ratio shows how much a company’s funding comes from debt relative to its equity or to its assets. When leverage is high, a larger portion of financing is fixed costs, like interest payments, that must be covered no matter how sales or earnings look. If business conditions worsen, those fixed obligations can strain cash flow, increasing the likelihood of default or distress and reducing financial flexibility. That combination—more debt with fixed costs and greater risk if earnings falter—is why high leverage is considered risky. It’s not primarily a liquidity measure (that looks at short-term obligations), nor a direct measure of profitability, and it doesn’t reflect market risk or reduce interest expenses.