Financial Leverage is related to 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 the total assets of the company are $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 in two ways
- New debt is issued
- Equity is replaced by new debt
How to Calculate Financial Leverage from Balance Sheet
The above table is related to the Capital Structure of a company with an 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 loans.
- If seasonal dip results in the 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 stockholders.
Financial Leverage Example:
The following example shows the effect of financial leverage on Income Statement & ROE.
The 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 an increase in debt. Increase from 21 to 22.5 (17.5+5)
- The increase of debt increases the risk in the shape of the standard deviation or uncertainty of ROE.
The impact of financial leverage and operating leverage on return on equity (ROE) is the same. In the case of high operating leverage, the company has high fixed costs and little change in quantity sold results in an increased change in NI & ROE.
If the sales of the company are below the break-even point then the operating leverage is much risky but if sales are above the break-even point then it drastically increases the ROE. In the case of high financial leverage, there is a high debt that increases the interest payments and little change in the EBIT results in a 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 the overall return of the company is higher than the 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 the levered company is high from 0 to 77% and the level of earning ranges from 50 to 600. In the case of an un-levered company, the level of earnings ranges from 3.5% to 42%. So it is cleared that the un-levered capital structure is better for a company whose sales are low.
But when the sales growth of the company is higher than the levered capital structure is more suitable because it gives the opportunity for high ROE.
The effect of leverage debt is also represented in the following graph on the basis of probability distributions.
On the x-axis, ROE is graphed while on the y-axis probability is shown. Two kinds of probability distributions are shown. The left side distribution is a tall & sharp peak which shows an un-levered company. The risk and average ROE is lower for un-levered company. The right side distribution is short & flatter that highlights a levered company having higher operating leverage. The risk & average ROE is higher for this company.
Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
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