Leverage ratio
Total liabilities divided by total assets — the personal finance ratio that measures how much of a household's asset build-up was paid for with debt.
In plain language
Two households can own the same Rs 65 lakh of assets and be in completely different positions. One bought them out of savings; the other bought them on loan and still owes most of it.
The leverage ratio separates the two. It is a measure of the role of debt in the asset build-up of the investor: of every rupee of assets, how many paise are still owed to someone else?
It is a balance-sheet ratio, read at a point in time. It says nothing about whether this month's income can pay this month's EMIs — that is the job of the debt to income ratio. The workbook is explicit that the leverage ratio has to be read in the context of debt servicing capability, never on its own.
How it works
The workbook's own illustration: an investor owns real estate worth Rs 50 lakh, investments and bank balances of Rs 10 lakh, and Rs 5 lakh in a provident fund account. The real estate was bought with a Rs 30 lakh loan of which Rs 10 lakh is still outstanding; there are also credit card dues of Rs 2 lakh and a Rs 1 lakh loan from a friend.
- Total assets = 50 + 10 + 5 = Rs 65 lakh
- Total liabilities = 10 + 2 + 1 = Rs 13 lakh (the outstanding amount, not the original Rs 30 lakh loan)
- Leverage ratio = 13 ÷ 65 = 20%
How to read it: higher the leverage, more risky the individual's financial situation. A ratio greater than 1 means the assets will not be adequate to meet the liabilities. The ratio is naturally high immediately after a large-ticket asset such as real estate is bought with debt, and it moderates over time as the asset appreciates and the loan is repaid.
The ratio is the mirror image of the solvency ratio: Leverage ratio = 1 − Solvency ratio. In the example, net worth is Rs 52 lakh and solvency is 52 ÷ 65 = 80%, which is 1 − 20%.
The formula
Leverage ratio = Total liabilities ÷ Total assets
Leverage ratio = 1 − Solvency ratio
A worked example
The figures below are illustrative, not from the workbook.
Mr Iyer, 34, has just bought a flat for Rs 80,00,000 with a home loan of Rs 64,00,000. He also has investments of Rs 12,00,000 and a car worth Rs 8,00,000 with a car loan of Rs 6,00,000 outstanding.
| Today | Five years later (assumed) | |
|---|---|---|
| Flat | Rs 80,00,000 | Rs 1,00,00,000 |
| Investments | Rs 12,00,000 | Rs 25,00,000 |
| Car | Rs 8,00,000 | Rs 3,00,000 |
| Total assets | Rs 1,00,00,000 | Rs 1,28,00,000 |
| Home loan outstanding | Rs 64,00,000 | Rs 50,00,000 |
| Car loan outstanding | Rs 6,00,000 | Nil |
| Total liabilities | Rs 70,00,000 | Rs 50,00,000 |
| Leverage ratio | 70% | 39.1% |
On the day of purchase the ratio is 70% — exactly the spike the workbook predicts right after a debt-funded large-ticket purchase. Nothing is wrong yet; the question is whether his income can carry the EMIs, which the debt to income ratio answers.
Five years on, with no new borrowing, the ratio has fallen to 50 ÷ 128 = 39.1% through two forces the workbook names: the flat appreciated, and the loan was repaid. Tracking the ratio year on year shows that trend; a single reading does not.
The warning case is the one the workbook flags in its last line: if Mr Iyer had instead borrowed against the flat to buy shares, he would be compounding a risky investment position with high leverage financing it.
Why NISM asks about it
Chapter 3 (Cash Flow Management and Budgeting), section 3.9.4, among the personal finance ratios in 3.9, with total assets at 3.9.2, total liabilities at 3.9.3 and the solvency ratio at 3.9.6. Expect a numeric question that lists assets, the original and outstanding loans, and a credit card balance, and asks for the ratio; and a conceptual one that contrasts it with the debt to income ratio — balance-sheet use of debt versus income's ability to service it.
Common exam traps
- Use the outstanding loan, not the original loan. The workbook example gives a Rs 30 lakh loan with Rs 10 lakh outstanding; only Rs 10 lakh goes in.
- Every liability counts — credit card dues and a loan from a friend included, not just bank loans.
- Leverage + solvency = 100%. If a question gives you one, the other is a subtraction.
- A ratio above 1 means assets cannot cover liabilities — negative net worth.
- Leverage ratio is not the debt to income ratio. Leverage measures debt used in acquiring assets; DTI measures the ability of monthly income to service debt. The workbook introduces DTI precisely because leverage does not measure servicing capacity.
- A high ratio just after buying a house is expected, and moderates as the asset appreciates. A high ratio that funds risky investments is the real danger.
Check yourself
1.The leverage ratio is calculated as:
- a)Total assets divided by total liabilities
- b)Total liabilities divided by total assets
- c)Net worth divided by total assets
- d)Monthly debt servicing divided by monthly income
Show the answer
Answer: (b) Total liabilities divided by total assets
"This is a measure of the role of debt in the asset build-up of the investor. It is calculated as Total Liabilities divided by Total Assets." Net worth over total assets is the solvency ratio, and monthly debt servicing over monthly income is the debt to income ratio.
2.If the leverage ratio is 20 per cent, what is the solvency ratio?
- a)20 per cent
- b)40 per cent
- c)80 per cent
- d)It cannot be determined
Show the answer
Answer: (c) 80 per cent
The solvency ratio "can also be calculated as 1 minus the Leverage Ratio. Similarly, Leverage Ratio = 1 minus Solvency Ratio." So 1 - 20 per cent = 80 per cent. In the chapter example, net worth of Rs 52 lakh over total assets of Rs 65 lakh gives exactly 80 per cent.
Where this is taught
Free preparation for NISM Series X-ARelated terms
- Debt to income ratioMonthly debt servicing commitment divided by monthly income — the ratio that says whether a household's income can carry the loans it already has, let alone another one.
- Net worthEverything you own minus everything you owe — the one number that says where a household actually stands, and the starting point of any financial plan.
- Personal balance sheetA statement of an individual's or household's assets and liabilities at a particular date, whose difference is net worth — the starting point for the personal finance ratios.
- Solvency ratioNet worth divided by total assets — the share of a household's assets it truly owns after all liabilities, and the complement of the leverage ratio.
- Total assetsThe current market value of everything an individual owns — physical and financial — and the figure from which total liabilities are subtracted to get net worth.
- Total liabilitiesEvery loan and unpaid bill a household owes — home loans, car loans, personal loans and card dues — added together; assets minus this figure gives net worth.
- LeveragingUsing borrowed funds rather than own funds to buy an asset — it can raise the return on the investment, and it magnifies the loss by the same mechanism.
- MortgageA loan secured by a charge on the property it funds: the borrower keeps the asset in his own name, and the lender can take it over and sell it if the loan is not repaid.
- Debt servicingAll payments a borrower owes a lender, whether principal or interest — the actual monthly outflow that every EMI, card payment and instalment adds up to, before it is turned into any ratio.
- Financial assets ratioThe share of an investor's total assets held in financial form — shares, deposits, mutual funds — rather than physical form such as gold or real estate, expressed as a percentage.