There are many definitions for the leverage ratio, but the one that we found most explanatory used the sum of senior liabilities in the numerator and tangible net worth plus subordinated debt in the denominator. 

Senior liabilities represent trade payables, accrued liabilities, third party interest-bearing debt, and so on.  It would also include loans from officers and owners if those loans were not subordinated.  Of course, all subordinated debt is removed from the senior liabilities total.

Tangible net worth is usually book net worth less intangible assets.  The definition of intangibles will vary.  For example, some lenders consider prepaid expenses to be intangible assets, similar to loan fees for term debt.

It is interesting that the leverage ratio generally had more explanatory value in predicting default than any measure of cash flow or any measure of profitability.  The most useful measure of cash flow was cash flow after debt repayment divided by sales, which allowed us to normalize the cash flow measure.  The most useful profitability measure was EBITDA %. 

You might wonder why the net profit margin had less predictive power than EBITDA.  We did, and speculated that the answer may be linked to one-time events that can impact the net profit margin but not EBITDA.  Further, the net profit margin for a Subchapter S corporation, partnership, limited liability company, and sole proprietorship does not include an income tax obligation, since the owners rather than the corporation pay the income tax obligation on company profit.  As a result, the reported net profit margin for these types of business organizations is virtually always overstated and, therefore, understandably a poor predictor of business default.

Your experience may differ from mine, but I’ve found it to be a rare occasion when I’ve witnessed an increase in the leverage ratio and decided – after a thorough assessment – that risk decreased rather than increased for the company in question.  I’d be curious about your experiences.