Financial Leverage is related with the debt. The extent or degree to which the total capital of the organization is composed of debt is referred to as financial leverage. So a company with 75% debt is highly leveraged. The formula of financial leverage is as follow:
FL (%) = Debt / Total Assets
It is clear that Total Assets = Debt + Equity, So
FL =Debt / Debt + Equity
If total assets of company are of $ 100 & its debt amounts $ 50 then its financial debt is 50% (50/100). This means that the company has 50% debt and 50% equity. The Financial Leverage of the company can be increased by two ways
- New debt is issued
- Equity is replace by new debt
How to Calculate Financial Leverage from Balance Sheet
The above table is related with the Capital Structure of a company with un-leverage case and leverage case. In case of un-leverage condition, the Assets = Equity = 100. On the other hand in case of leverage condition, the company has 50% debt and 50% equity. The company replaced 50% of its equity into debt by taking loan.
- If seasonal dip results into falling of EBIT below the interest payment than the increase in debt increases the chances of net loss for the company.
- The uncertainty in ROE is increased with the increase in debt. The spread or range of possible future values of ROE increases which results in the increase of risk bear by common stock holders.
Financial Leverage Example:
Following example shows the effect of financial leverage on Income Statement & ROE.
Following points are derived from the above table
- The ROE is improved or levered up to 35% by increasing debt
- The total return to investors (NI + Interest) is also increased with the increase in debt. Increase from 21 to 22.5 (17.5+5)
- The increase of debt increases the risk in the shape of standard deviation or uncertainty of ROE.
The impact of financial leverage and operating leverage on return on equity (ROE) is same. In case of high operating leverage, the company has high fixed costs and little change in quantity sold results in increased change in NI & ROE. If the sales of company are below break-even point then the operating leverage is much risky but if sales are above break-even point then it drastically increase the ROE. In case of high financial leverage, there is high debt which increases the interest payments and little change in the EBIT results in drastic increase in Net Income & ROE. High financial leverage is risky if the company is not able to pay the additional interest payments timely and when overall return of company is higher than cost of debt, than high financial leveraging drastically increases. The effect of financial leverage on ROE is better understood from the following table.
The ROE of levered company is high from 0 to 77% and the level of earning range from 50 to 600. In case of un-levered company, the level of earnings range from 3.5% to 42%. So it is cleared that the un-levered capital structure is better for company whose sales are low. But when the sales growth of company is higher than levered capital structure is more suitable because it gives opportunity for high ROE.
The effect of leverage debt is also represented in the following graph on the basis of probability distributions.
On x-axis ROE is graphed while on y-axis probability is shown. Two kinds of probability distributions are shown. The left side distribution is tall & sharp peak which shows un-levered company. The risk and average ROE is lower for un-levered company. The right side distribution is short & flatter that highlights levered company having higher operating leverage. The risk & average ROE is higher for this company.