What is financial leverage?
Financial leverage refers to the use of debt to invest in the expansion of a firm’s asset base and generate returns of risk capital. In simple terms, it is the use of borrowed funds to buy more assets. Financial leverage is an investment strategy of making use of borrowed money specifically the use of financial instruments or borrowed capital in order to increase the potential return on investment.
We can say that financial leverage is a means through which individuals or companies go into debt in order to purchase an asset. Financial leverage is also employed to increase the return on equity. However, if the amount of financial leverage of a firm is excessive, the risk of failure will increase because it becomes more difficult to repay debt.
One of the financial leverage formulas is measured as the ratio of total debt to total assets, which is also known as the debt-to-asset ratio. As the proportion of debt to assets increases, the amount of financial leverage correspondingly increases. Financial leverage becomes favorable a firm can put the debt to use such that it generates returns greater than the interest expenses associated with the debt. Many companies make use of financial leverage rather than acquiring more equity capital which could bring about a decrease in the earnings per share of existing shareholders.
When a firm uses debt (borrowed capital) in order to undertake an investment or project, it is called financial leverage. While the result is to multiply the potential returns from the project, leverage will, at the same time, multiply the potential downside risk in case the investment fails to pan out. When a company, property, or investment is referred to as highly leveraged, it implies that the item has more debt than equity.
The concept of financial leverage is used by both investors and companies. Investors make use of leverage to significantly increase the returns on investment. They lever their investments by making use of various instruments which include options, futures, and margin accounts.
Any individual or company may make use of financial leverage to purchase an asset that they otherwise were unable to. A family or household may make use of financial leverage to increase their asset purchasing power as well as to multiply their returns.
Financial leverage is of benefit when the debt is able to generate returns that are greater than the loan’s interest expenses. For example, if a factory being purchased by a company produces a profit that is greater than the debt repayment.
Financial leverage example
We can look at a hypothetical company that used $100,000 of its own cash and a loan of $900,000 to buy a new factory that is worth a total of $1 million. The factory generates an annual profit of $150,000 on a $100,000 cash investment. This means that the return on investment that the company generated is 150%.
Types of financial leverage
- Leveraged investing
- Leverage for personal finances
- Leverage in professional trading
Investors may make use of leverage if they want to invest more than they can afford with the available cash they have. The term used for this type of leverage is buying on the margin, which allows investors to increase their returns on investment. Generating returns on investment is only possible if their investments perform better than the loan itself. For example, an investor who buys on the margin may have control over $100,000 worth of securities with $50,000 of their own money. Investors are bound to incur considerable losses and gains through this strategy, however, newer or less experienced investors buy on the margin.
Leverage for personal finances
Individuals may also make use of leverage to make large and one-off purchases. In this case, they may take out a loan to purchase an asset such as a motor vehicle or to grow their capital in the future. For example, an individual may go into debt to invest in a house that has a likelihood of increasing in value. They may also take out a loan to invest in a side business that has the potential of producing profit as well as give them the capital they otherwise may not have.
Leverage in professional trading
This type of leverage is similar to buying on the margin, just that it offers more significant returns and higher risk. It can increase the ability of traders to purchase shares by allowing them to take them on higher levels of borrowed funds or capital. Professional investors usually have higher limits on the capital they borrow and the requirements that they have to follow may be different from that of non-professionals. High knowledge of knowledge, depth of experience, and the acceptance of significant risk are required in this form of leverage.
Financial leverage ratios
- Debt-to-asset ratio
- Debt-to-equity ratio
- Debt-to-EBITDA ratio
- Equity multiplier
- Return of equity (ROE)
- Return on assets (ROA)
- Earnings per share
There is an entire suite of financial leverage ratios that are used to calculate the amount of debt a company is leveraging in an attempt to maximize profits. Several financial leverage ratios are listed above and will be further explained.
The debt to asset ratio is a financial leverage ratio of a company that compares a company’s debt obligations, both short-term and long-term debts to a company’s assets. In other words, it defines the amount of debt relative to the total assets owned by a company. It helps analysts, creditors, and investors determine how solvent a company is.
A company can analyze its leverage by taking a look at what percentage of its assets have been purchased using debt. In order to find the equity-to-asset ratio, a company can subtract the debt-to-asset ratio by 1. If the debt to asset ratio is high, it is an indication that the company has relied on leverage to finance its assets.
The debt to asset ratio is calculated by dividing the total debt of a company by its total assets. It is represented in a formula as;
Debt to assets ratio = Total debt / Total assets
The debt to equity ratio is another metric used to evaluate a company’s financial leverage. It is used in corporate finance as it measures the degree to which a company is financing its operations through debt against wholly owned funds. The debt-to-equity ratio reflects the ability of shareholders’ equity to cover all outstanding debts in cases where the business is experiencing a downturn.
Instead of focusing on what the company owns, a company can measure its financial leverage by strictly looking at how assets have been financed. With this, the debt-to-equity ratio compares the amount the company has borrowed to what it has raised from private investors or shareholders.
When a debt to equity ratio is greater than 1, it means that the company has more debt than equity. However, this does not necessarily mean that the company is highly leveraged. Typically, each company and industry will operate in a specific way that will warrant either a higher or lower ratio. For example, start-up technology companies may struggle to secure financing and oftentimes must turn to private investors. With this, we may still consider the debt to equity ratio of 0.5 to be high for this industry compared.
The formula for calculating debt to equity ratio is;
Debt-to-Equity Ratio = Total debt / Total equity
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The debt to EBITDA ratio is a financial metric that measures the amount of income generated and available to pay off debt before covering interest, taxes, depreciation, and amortization expenses. It measures the ability of a company to pay off its incurred debt. When the ratio is high, it could be an indication that the company has a high debt load.
A company can also compare its debt to the income it generates in a given period. The company will want to know the debt in relation to operating income that is controllable. With this, it is common to make use of EBITDA instead of net income. A company with a high debt-to-EBITDA ratio is carrying a high degree of weight compared to what it makes. In essence, the higher the debt to EBITDA ratio, the more leveraged the company is. It is represented in a formula as;
Debt-to-EBITDA = Total Debt / Earnings before interest, taxes, depreciation, and amortization
The equity multiplier is a risk indicator and it measures the portion of a company’s assets that is financed by shareholders’ equity rather than debt. Although debt is not directly considered in the equity multiplier, it is included in total assets and total equity. Each of these elements has a direct relationship with total debt. The equity multiplier attempts to understand a company’s ownership weight by analyzing how assets are financed. If a company has a low equity multiplier, it suggests that it has financed a large portion of its assets with equity. This also means that the company is not highly leveraged. The DuPont formula makes use of the equity multiplier to measure financial leverage.
The equity multiplier is calculated using the total assets of a firm by the value of its total equity. It is represented in a formula as;
Equity Multiplier = Total assets / Total equity
Return on equity (ROE)
The return on equity measures a company’s profitability in relation to its equity. An investor may make use of the figure to determine how a capital deploys its capital and the amount of the capital it borrows. Typically an ROE of around 14% is considered to be acceptable by companies. It is calculated by dividing a company’s net income and shareholders’ equity.
ROE = net income / equity
Return on assets (ROA)
Return on assets is a metric that shows how profitable a company is in relation to its total assets. Investors, analysts, and corporate management make use of ROA to determine how efficiently a company uses its assets to generate a profit. A higher return on assets implies that the company is more efficient at managing its balance sheet to generate profits. The ROA is calculated as net income divided by total assets, that is;
ROA = net income / total assets
Earnings per share (EPS)
The earnings per share (EPS) is the monetary value of earnings per outstanding share of common stock of a company. It can reveal the value a company makes for each share of its stock, it estimates corporate value. If a company has a high EPS, it indicates a greater value. If investors believe that the company has higher profits relative to its share price, they are likely to pay more for its shares. It is calculated as net income divided by the number of shares, that is;
EPS = net income / number of shares
Factors affecting financial leverage
- Second stage leverage
- Financial liability
- Financing decision
- Interest rates
- Return on assets
- Fixed financial cost
Second stage leverage
Financial leverage is seen as second-stage leverage because it depends on the degree of operating leverage. If the operating risk is high, the company will plan for low financial leverage and if the operating risk is low, the company will plan for high financial leverage.
The borrowings that take the form of debts create financial liability for the company. The amount of financial liability will determine the amount of debt a firm will take on to finance its assets. A firm incurring a high financial liability will not want to add to its liability.
A company’s financial leverage decision is a part of its financing strategy planned by the directors.
Certainly, borrowings are usually payable with interest which is quite high. The higher the interest rate, the lower a company will want to take on debt to finance its assets.
A firm’s position and stability are the most important factors that the management considers while making the financing decision of a company. It is riskier for an unstable firm to become highly leveraged.
Return on assets
A company must estimate its return on assets to find out whether the company will be able to generate higher profits or not. A leveraged company will face financial risk if it is unable to generate higher profits on the capital employed.
Fixed financial cost
The debts incurred by a company create a fixed financial burden in the form of interest on the company.
Degree of financial leverage (DFL)
The degree of financial leverage is a ratio that measures how sensitive a company’s earnings per share are to its operating income as a result of the changes that occur in its capital structure. This financial metric measures the percentage change in earnings per share (EPS) for a unit change in operating income which is also known as earnings before interest and taxes (EBIT).
This ratio indicates that earnings become more volatile when the degree of financial leverage is higher. Since interest is usually a fixed expense, financial leverage magnifies returns and earnings per share. This is good when there is a rise in the operating income. On the other hand, it can be a problem when operating income is under pressure.
Degree of financial leverage formula
The degree o financial leverage is calculated by dividing the percentage change in a company’s earnings per share (EPS) by the percentage change in its earnings before interest and taxes (EBIT) over a specific period. The goal of this calculation is to understand a company’s sensitivity to earnings per share based on changes in operating income. A higher DFL indicates a higher degree of financial leverage and this also means that the company is likely to have more volatile earnings.
The degree of financial leverage formula is represented as;
DFL = % Change in Earnings Per Share / % Change in EBIT
Benefits of financial leverage
- Amplifies shareholder profits
- Improves credit rating
- Captures economies of scale
- Increased free cash
Amplifies shareholder profits
If a company’s assets and operations are solely financed by shareholders’ equity, then its profitability to the shareholders will change in proportion to its own change in profitability. For example, if profits increase by 10%, then the dividends of shareholders or share value will increase by 10%. If the company is leveraged, then the increase in profitability of the operation will not bring about an increase in the payments needed to service the debt. The excess profit is then passed to shareholders and this will necessarily bring about an increase in the value of shares or dividends to a greater degree than the increase in the firm’s profitability.
Improves credit rating
A firm that is successful in using leverage can handle risks that are associated with carrying debt, this can become an important factor when there is a need for additional financing. Loans will not just be more likely available, they will be available at more attractive interest rates. Just like individuals, companies that have solid financials but little credit history sometimes have trouble convincing lenders that they deserve a good rate.
Captures economies of scale
Some activities in a company become more efficient when they are conducted on a larger scale. Such activity includes industrial mass production. Generally, larger production facilities incur a lower cost per unit in producing goods. Since this is of great advantage to the company both to offer many items for sale and to compete by offering a lower price to the consumer, larger facilities are often preferable. If a company cannot afford a larger production facility, then borrowing may be the best option.
Increased free cash
By borrowing funds, the company incurs a debt that must be paid off. However, the company makes this debt payment in installments over a relatively long period of time. This way, funds are freed for more immediate use. For example, if a company can afford a new factory but will be left with negligible free cash, it may be better off if it finances the factory and spend the cash at hand on factor inputs such as labor, or even hold a significant portion as a reserve against unforeseen events.
Disadvantages of financial leverage
- Increase in financial risk
- More expensive for a company
- Complex operation
Increase in financial risk
Although debt is a source of financing that can help a business grow faster, it can magnify a firm’s risk exposure when leverage becomes higher than normal. In other words, using leverage can increase a firm’s downside risk which may result in losses greater than the initial capital investment.
In addition to that, brokers and contract traders will charge fees, premiums, and margin rates. Even if a company loses on its trade, it must have to pay for those extra charges.
Another downside risk associated with financial leverage is that it can be complex. Investors have to be aware of their financial position as well as the risks they will inherit when entering into a leveraged position.
This may call for additional attention to one’s portfolio and additional capital contribution in case their trading account does not have a sufficient amount of equity per their broker’s requirement.
More expensive for a company
Financial leverage is more expensive for a company in the sense that products such as loans and high-yield bonds pay higher interest rates to compensate investors for taking more risks.
The financial instruments that are involved in this case such as subordinated intermediate debt are more complex. This complexity requires additional management time as well as involves several risks.
What is financial leverage example?
A company had $100,000 of its own cash and took a loan of $900,000 to buy a new factory that is worth a total of $1 million. The annual profit generated by the factory is$150,000 on a $100,000 cash investment. The return on investment is 150%.
What is good financial leverage?
Financial leverage is good when the firm generates returns that are greater than the interest expense associated with the debt. This is because the interest on a loan is fixed even if profits increase. If on the other hand, the interest expense associated with the debt is greater than the return that a firm generates, then the firm is faced with financial risks.