Leverage, in particular financial leverage, is the amount of debt that an entity uses to buy more assets. In corporate finance, debt financing is a well-known term, which is used as a tool by companies to ensure smooth business operations. Since companies have limited funds, they need exogenous funding to boost their financial resources from time to time for expansion of operations.

Even with the option for equity financing, companies prefer borrowing funds as these are easily and cheaply available. Moreover, using financial leverage rather than acquiring more equity capital is favored as equity financing reduces the earnings per share of existing shareholders.

Yet the word “debt” is unnerving for many.  This is because while debt brings with it the capacity to spend a little bit more, it also carries the burden of repayment with additional interest in the future.In fact, the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is a particular problem when interest rates rise or the returns from assets decline.

Also when theamount of debt a company bears becomes exorbitant, it poses greater risk. In fact, companies with high debt loads are more vulnerable during economic downturns and can even go bankrupt.

Considering this and the fact that analysts are currently estimating a hike in U.S. interest rates at the upcoming Fed meet this month, investors may feel shaky. Nevertheless, this does not indicate that one should totally dissuade from equity investment.

What investors need now is tochoose stocks prudently, avoiding those with high debt loads. So the crux of safe investment lies in identifying low leverage stocks.

And here comes the importance of leverage ratios, which have been constructed historically to safeguard investors from becoming victims of debt trap. Debt-to-equity ratio is one such measure, perhaps the most popular one, to evaluate a company’s credit worthiness, for potential equity investments.