Definition and Meaning of Financial Leverage
Financial leverage can be aptly described as the extent to which a company or investor uses the money it has borrowed. Businesses with high leverage are considered to be at risk of bankruptcy if they are unable to repay the debt, it could lead to difficulties in getting new lenders in the future. It is not that financial leverage is always bad. However, it can lead to a higher return on investment for shareholders. Also, there are often tax benefits associated with borrowing, also known as leverage.
Debt-to-equity ratio = Total debt / Shareholders Equity
Financial Leverage Calculation
Financial leverage indicates a company's reliance on its debt to operate. Understanding the method and technique of calculating financial leverage can help you determine a company's financial solvency and its dependence on its debt. The key steps involved in calculating financial leverage are:
- Calculate the total debt owed by the company. This includes both short-term and long-term debt, as well as assets such as mortgages and money owed for services rendered.
- Estimate the total equity owned by the company's shareholders. To do this, multiply the number of shares outstanding by the stock price. The total you get is your shareholders' equity.
- Divide total debt by total equity. The resulting quotient is the financial leverage ratio.
Standards and Limits
If a company's debt-to-equity ratio is greater than 2 to 1, it is financially weak. If the company is highly leveraged, it is considered to be on the verge of bankruptcy. It may also be unable to secure new capital if it is unable to meet its current obligations.
A company that has a high level of financial leverage is said to be highly leveraged, meaning that it has a significant amount of debt relative to its equity. This can increase the risk of the company's financial performance, but it can also increase the potential return on investment for shareholders.
One of the most common questions about financial leverage is how it affects a company's risk and return. Leverage can amplify the returns on an investment, but it also increases the risk of financial loss. When a company takes on debt, it is essentially borrowing money to invest in its operations, which can lead to higher returns if the investments are successful. However, if the investments do not perform as well as expected, the company may have difficulty paying off its debt and could default on its loans. This can lead to financial losses for the company and its shareholders. Therefore, it is important for investors to consider the potential risks and returns associated with a company's leverage when evaluating an investment opportunity.
Does financial leverage depend on the size of the company? In general, small companies tend to have greater financial leverage than large companies. Small companies often have limited access to capital and may not have the same ability to raise funds through equity offerings as larger companies. As a result, they may rely more heavily on debt financing to fund their operations and growth. Additionally, small companies may not have the same level of profitability or cash flow as larger companies, which can make it more difficult for them to service their debt.
However, it's worth noting that this is a general trend and it is not always the case, as there may be large companies that are highly leveraged and small companies that have low leverage. Financial leverage is a decision made by the management and it can vary among companies regardless of their size.
It is important to evaluate the financial leverage of a company on a case-by-case basis, by looking at the company's financial statements and ratios, as well as its industry and competitive landscape.
Other Financial Leverage Ratios
In addition to the debt-to-equity ratio, there are several other ratios that can be used to estimate a company's financial leverage:
Interest Coverage Ratio: This ratio compares a company's operating income to its interest expenses. It shows how easily a company can pay its interest expenses. A lower ratio indicates a higher level of leverage.
Debt-to-Asset Ratio: This ratio compares a company's total debt to its total assets. It shows how much of the company's assets are financed by debt. A higher ratio indicates a higher level of leverage.
Current Ratio: This ratio compares a company's current assets to its current liabilities. It shows a company's ability to pay its short-term debt. A lower ratio indicates a higher level of leverage.
Times Interest Earned Ratio: This ratio compares a company's operating income to its interest expenses. It shows how many times a company's operating income can cover its interest expenses. A lower ratio indicates a higher level of leverage.
These ratios are commonly used to assess a company's financial leverage and creditworthiness.