Financial Leverage

Financial Leverage- The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on investment and often there are tax advantages associated with borrowing. also called financial leverage.

The use of borrowed money to increase production volume, and thus sales and earnings. It is measured as the ratio of total debt to total assets. The greater the amount of debt, the greater the financial leverage.

Since interest is a fixed cost (which can be written off against revenue) a loan allows an organization to generate more earnings without a corresponding increase in the equity capital requiring increased dividend payments (which cannot be written off against the earnings). However, while high leverage may be beneficial in boom periods, it may cause serious cash flow problems in recessionary periods because there might not be enough sales revenue to cover the interest payments.

Financial leverage can be aptly described as the extent to which a business or investor is using the borrowed money. Business companies with high leverage are considered to be at risk of bankruptcy if, in case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in future. It is not that financial leverage is always bad. However, it can lead to an increased shareholders’ return on investment. Also, very often, there are tax advantages related with borrowing, also known as leverage.

Calculating financial leverage

Financial leverage indicates the reliability of a business on its debts in order to operate. Knowing about the method and technique of calculating financial leverage can help you determine a business’ financial solvency and its dependency upon its borrowings. The key steps involved in the calculation of Financial Leverage are:

Compute the total debt owed by the company. This counts both short term as well as long term debt, also including commodities like mortgages and money due for services provided.

Estimate the total equity held by the shareholders in the company. This requires multiplying the number of outstanding shares by the stock price. The total amount thus obtained represents the shareholder equity.

Divide the total debt by total equity. The quotient thus obtained represents the financial leverage ratio.

Formula

The most well known financial leverage ratio is the debt-to-equity ratio (see also debt ratio, equity ratio). 

It is calculated as:

Total debt / Shareholders Equity