Financial Leverage : Importance, Formula, Calculation & Advantages

What is Financial Leverage?

Financial leverage involves using borrowed funds (debt) to acquire assets, anticipating that the returns will exceed borrowing costs, and aiming to enhance the return on equity. Key aspects include leveraging debt for increased returns, heightened sensitivity to economic cycles, and the association of higher debt-to-equity ratios with elevated financial risk. It finds application in real estate, stocks, and business expansion decisions. The decision to employ financial leverage depends on factors like expected returns, debt-handling capacity, and prevailing interest rates. While it can amplify returns, its excessive use may expose a company to significant risks, requiring a careful balance between its advantages and disadvantages.

Geeky Takeaways:

• Financial leverage includes utilizing borrowed funds (debt) to acquire assets with the anticipation that returns will surpass borrowing costs, enhancing the return on equity.
• The pivotal aspects of financial leverage include leveraging debt for increased returns, heightened sensitivity to economic cycles, and the association of higher debt-to-equity ratios with elevated financial risk.
• Financial leverage is applicable in various sectors, such as real estate, stocks, and business expansion decisions.
• The decision to employ financial leverage depends on factors like expected returns, debt-handling capacity, and prevailing interest rates.
• Employing financial leverage requires a careful balance between its advantages and disadvantages.

Why is Financial Leverage Important?

1. Profit Amplification: Financial leverage allows a company to amplify its profits by using borrowed funds to invest in assets that have the potential to generate higher returns than the cost of borrowing. This can result in increased earnings for shareholders.

2. Return on Equity (ROE): Financial leverage is directly linked to a company’s return on equity. By using debt to finance a portion of its operations, a company can potentially achieve a higher ROE than if it relied solely on equity. This is because the cost of debt is often lower than the return on equity.

3. Capital Efficiency: Leverage can make a company’s capital structure more efficient by balancing the use of equity and debt. This allows the company to optimize its capital and use it more effectively to fund projects, make acquisitions, or pursue growth opportunities.

4. Tax Shield: Interest payments on debt are typically tax-deductible, providing a tax shield for leveraged companies. This means that the interest expense reduces taxable income, leading to lower corporate taxes and potentially higher after-tax profits.

5. Risk and Return Balancing: Financial leverage enables companies to take on more risk in pursuit of higher returns. However, it’s essential to strike a balance because excessive leverage also increases financial risk. Managing this balance is crucial for optimizing the risk-return tradeoff.

Financial Leverage Formula

The formula for calculating the financial leverage ratio compares a firm’s average total assets to its average shareholders’ equity. The financial leverage ratio is determined by dividing the average total assets by the average shareholders’ equity. The average total assets are calculated as the sum of the beginning and ending total assets, divided by two, while the average shareholders’ equity is computed as the sum of the beginning and ending total equity, divided by two. Both total assets and total shareholders’ equity are components found on a firm’s balance sheet. The formula used for financial leverage is as follows,

[Tex]Financial~Leverage~Ratio=\frac{Average~Total~Assets}{Average~Shareholders’~Equity}[/Tex]

Where,

[Tex]Average~Total~Assets~=\frac{(Total~Assets~in~the~Beginning+Ending~Total~Assets)}{2}[/Tex]

[Tex]Average~Shareholders’~Equity=\frac{(Total~Equity~in~the~Beginning+Ending~Total~Equity)}{2}[/Tex]

The financial leverage ratio represents a measure of the proportion of a firm’s assets financed by debt as opposed to equity. The ratio offers insights into the extent to which a company’s assets are financed by debt.

How to Calculate Financial Leverage?

Financial leverage is a strategic approach adopted by corporations to secure capital from lenders, enabling them to fulfill ongoing operational needs and fund capital expenditures (Capex). This financial strategy involves utilizing two primary sources of capital, equity capital and debt capital.

• Equity Capital: Equity capital is acquired through the issuance of common shares, representing partial ownership of a firm. Investors contribute capital by purchasing these shares, but unlike lenders, they do not receive dividends. Each share entitles the holder to a stake in the total equity of the underlying issuer.
• Debt Capital: Debt capital is procured through debt securities, including loans and bonds. In exchange for periodic interest and principal payments, corporations borrow funds. The size of interest payments is determined by the interest rate on the debt and the remaining principal.

Financial leverage serves as a vital funding source for companies, addressing both working capital needs and the acquisition of fixed assets (PP&E) crucial for core operational activities that generate revenue. Importantly, it permits firms to manage these requirements without resorting to raising equity, commonly known as trading on equity. The relevance of financial leverage lies in its potential to enable firms to achieve higher returns, capitalize on the tax-deductibility of interest, and allocate more capital toward growth and expansion initiatives. This strategic use of debt provides firms with the flexibility to navigate financial landscapes, unlocking avenues for increased returns and fostering opportunities for sustained growth.

Advantages of Financial Leverage

1. Enhancing Shareholder Returns: Financial leverage acts as a powerful tool for companies to not only grow their profits but also to do so at a pace that outstrips the growth of their equity capital. It means that shareholders can potentially enjoy higher returns on their investments as the company leverages its resources to maximize profitability.

2. Building Strong Credit Ratings: A proficient management of financial leverage is not just about borrowing funds but also about showcasing a company’s capability to handle debt responsibly. Successfully demonstrating this responsibility can lead to an improved credit rating. A favorable credit rating, in turn, opens doors to better financial terms, lower interest rates on borrowings, and increased confidence from investors and creditors.

3. Unlocking Economies of Scale: One of the significant advantages of financial leverage is its ability to facilitate investments in larger facilities. This strategic move permits firms to capture economies of scale, which involves producing more units at a lower average cost. By doing so, companies can optimize their operational efficiency, reduce costs per unit, and ultimately enhance their competitiveness in the market.

4. Boosting Free Cash Flow: Strategic use of debt can liberate cash for various purposes. Whether it’s funding essential input purchases, initiating new projects, or establishing reserves for unexpected events, increased free cash flow provides a company with greater financial flexibility. This flexibility, in turn, enables the firm to adapt to changing circumstances and capitalize on emerging opportunities.

5. Tax Advantages: The tax advantages associated with financial leverage are notable. Interest payments on debt are tax-deductible, providing a valuable tax shield. This tax benefit not only limits the overall tax burden on the company but also serves as an incentive for choosing debt financing over equity financing in certain situations.

6. Gaining a Competitive Edge: Financial leverage contributes to a firm’s competitive edge by empowering it to make strategic moves in the market. Whether it’s offering lower prices to attract cost-conscious consumers or expanding product lines to cater to a broader audience, financial leverage provides companies with the financial muscle to compete more effectively in the dynamic business landscape. This competitive edge is crucial for long-term sustainability and growth in the market.

Disadvantages of Financial Leverage

1. Increased Financial Risk: Financial leverage heightens a firm’s financial risk by intensifying its exposure to market fluctuations and changes in interest rates. When a company takes on a higher-than-normal level of debt, it enters a leveraged state that may be too high, significantly amplifying its vulnerability to various risk factors. Proactive risk management strategies are crucial to navigating the challenges associated with increased financial risk.

2. Higher Cost: Utilizing leveraged financial products, such as leveraged loans and high-yield bonds, results in higher interest rates. These elevated rates are offered to compensate investors for assuming greater risk. Consequently, the company faces increased costs when borrowing money, impacting its overall financial expenses. Managing these heightened costs necessitates careful financial planning and efficient allocation of resources.

3. Complexity: The involvement of financial instruments like subordinated intermediate debt introduces complexity into financial leverage strategies. Managing this complexity demands additional time from the firm’s management and brings forth various associated risks. Navigating the intricacies of these instruments requires careful attention to detail. Companies must invest in robust management systems to effectively handle the complexity associated with leveraged financial instruments.

4. Amplified Losses: If the performance of underlying investments falls short of expectations, financial leverage can significantly magnify losses. This amplification exposes the firm to substantial risk, as the impact of unfavorable outcomes is heightened, potentially leading to severe financial setbacks. Developing contingency plans and stress-testing investment scenarios becomes imperative to mitigate the risks of amplified losses.

5. Vulnerability to Market Fluctuations: Financial leverage renders a company more susceptible to sudden market fluctuations. These fluctuations, if not anticipated or managed effectively, can result in significant losses for the company. The increased vulnerability underscores the importance of vigilant risk management practices. Regular monitoring of market conditions and swift adaptive measures are essential to navigating the dynamic nature of financial markets.

6. Overleveraging Risk: Excessive borrowing, a consequence of overleveraging, poses a substantial risk for companies. This situation can lead to financial challenges, making it challenging for the company to meet its debt obligations. Overleveraging risk highlights the importance of maintaining a balance in the level of debt assumed to avoid potential financial difficulties. Regular assessments of the company’s debt structure and adjustments to prevent overleveraging are critical for financial stability.

Difference Between Financial Leverage and Margin

Basis	Financial Leverage	Margin Trading
Definition	Financial leverage entails utilizing borrowed funds to finance investments or projects, aiming to increase returns on equity capital.	Margin trading involves borrowing money from a broker to purchase securities, options, or futures contracts, using existing cash or securities as collateral.
Application	Firms commonly employ financial leverage to amplify profits and access expensive investment opportunities.	Investors utilize margin trading to trade larger positions than the amount of cash in their account, enhancing their potential returns.
Calculation	Measured by the ratio of total company debt to shareholders’ equity.	Calculated as the total amount invested, including cash brought in, funds borrowed, and the collateral value of shares or securities offered.

Frequently Asked Questions (FAQs)

What does leverage ratio mean?

A leverage ratio is a financial measurement that assesses how much of a firm’s capital is derived from debt, such as loans. It evaluates the firm’s ability to fulfill its financial obligations.

What is considered a good financial leverage ratio?

A financial leverage ratio of less than 1 is generally deemed good according to industry standards. Ratios exceeding 1 may categorize a company as a risky investment, and ratios surpassing 2 are cause for concern among lenders and potential investors.

Is leverage in finance inherently good or bad?

Leverage is neither inherently good nor bad; its impact depends on the situation. Leverage can be advantageous for growth and expansion opportunities, permitting businesses and individuals to pursue ventures that might be financially challenging otherwise.

What does a good activity ratio mean?

A good activity ratio is characterized by a higher turnover ratio, indicating that the company can generate more revenue with fewer assets. A higher turnover ratio is considered favorable.

Why is financial leverage considered risky?

Financial leverage introduces increased risk due to the additional cash flow required to service debt. This heightened pressure on cash flow can elevate the risk of insolvency and bankruptcy, particularly during economic downturns.