Leverage, or financial leverage, is the use of borrowed funds (money) to buy assets or securities in the expectation that the income from the asset will exceed the borrowing cost.
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What is Financial Leverage?
Leverage, also known as financial leverage, is a type of investment in which borrowed money or debt is used to maximize investment returns, raise funds for a company, or acquire additional assets.
Individuals or businesses create debt by borrowing money or capital from lenders and promising to repay it with interest. Thus, leverage can also refer to equity trading.
When a company or an individual business is considered highly leveraged, their debt exceeds its equity. Knowing this allows investors to make better decisions before investing in any firm, or company.
Understanding Leverage
Leverage is one of the most common words used in finance. Be it an individual or a company, leverage is used to generate profit that is higher than the cost of borrowing.
- Investors use leverage to significantly increase the potential returns on their investments. They leverage their investments through a variety of instruments, including options, futures, and margin accounts.
- Companies can use leverage to fund their assets. In other words, rather than issuing stock to raise capital, businesses can use debt financing to invest in their operations and influence growth.
How to Calculate Financial Leverage
1. Debt-to-Equity Ratio
Debt-to-Equity Ratio=Total Debt/Equity
Explanation:
- Measures how much debt a company uses relative to equity to finance its operations.
- A higher ratio indicates higher reliance on debt, increasing financial risk.
- A lower ratio suggests a conservative approach to financing with more reliance on equity.
2. Asset-to-Equity Ratio
Asset-to-Equity Ratio=Total Assets/Equity
Explanation:
- Indicates the proportion of a company’s assets funded by shareholders’ equity.
- A higher ratio means more assets are funded through debt and other liabilities.
- A lower ratio shows that equity is contributing more significantly to asset funding.
Company XYZ Financials:
- Total Debt: ₹1,00,000
- Equity: ₹50,000
- Total Assets: ₹1,50,000
Step-by-Step Calculations:
Debt-to-Equity Ratio
Asset-to-Equity Ratio
Asset-to-Equity Ratio=Total Assets/Equity=1,50,000/50,000=3.0
Interpretation: The company has ₹3 in assets for every ₹1 of equity, implying significant use of liabilities (debt + others) to fund assets.
Degree of Financial Leverage (DFL)
Fundamental analysts can also use the degree of financial leverage (DFL) ratio. The DFL is calculated by dividing the percentage change of a company’s earnings per share (EPS) by the percentage change in its earnings before interest and taxes (EBIT) over a period.
The goal of DFL is to understand how sensitive a company’s EPS is based on changes to operating income. A higher ratio will indicate a higher degree of leverage, and a company with a high DFL will likely have more volatile earnings.
Advantages and Disadvantages of Financial Leverage
Advantages
Financial leverage offers several benefits to businesses and investors. It can significantly amplify returns on equity during profitable periods, making it an effective tool for maximizing shareholder value.
The use of debt also comes with tax benefits, as interest payments are tax-deductible, which reduces the overall cost of borrowing. Additionally, financial leverage allows companies to undertake large projects without issuing additional equity, thereby avoiding ownership dilution.
It also boosts growth potential by enabling businesses to access funds for expansion, investments, and other strategic opportunities. When managed prudently, leverage can be a powerful driver of growth and profitability.
Disadvantages
Despite its advantages, financial leverage carries inherent risks. Excessive reliance on debt increases financial risk, as fixed obligations like interest and principal repayments must be met regardless of the company’s performance. This makes businesses more vulnerable during economic downturns or periods of declining revenues.
Leverage also magnifies losses, making financial outcomes more volatile and unpredictable. Additionally, high debt levels can negatively impact a company’s credit rating, increasing borrowing costs and limiting future financial flexibility.
If mismanaged, financial leverage can lead to insolvency and jeopardize the company’s stability.
Final Thoughts
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