Meaning and definition of financial leverage
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.
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
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.
Norms and Limits
If the financial leverage ratio of a company is higher than 2-to-1, it indicates financial weakness. If the company is leveraged highly, it is considered to be near bankruptcy. Also, it might not be able to secure new capital if it is incapable of meeting its current obligations.