financial leverage

It´s a ratio of a company’s loan capital (debt) to the value of its ordinary shares (equity); this is also called gearing: (debt/Equity). A firm’s debt-to-equity ratio also impacts the firm’s borrowing costs and its value to shareholders.

The debt-to-equity ratio is a measure of a company’s financial leverage calculated by dividing its total liabilities by stockholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets. For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders.

However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. Insufficient returns can lead to bankruptcy and leave shareholders with nothing. 

financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company’s bottom-line earnings per share (EPS).

Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company’s capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company. ‘Degree Of financial leverage – DFL’ – A leverage ratio summarizing the affect a particular amount of financial leverage has on a company’s earnings per share (EPS). financial leverage involves using fixed costs to finance the firm, and will include higher expenses before interest and taxes (EBIT).

The higher the degree of financial leverage, the more volatile EPS will be, all other things remaining the same. Most likely, the firm under evaluation will be trying to optimize EPS, and this ratio can be used to help determine the most appropriate level of financial leverage to use to achieve that goal. The formula is as follows: DFL = % Change in EPS / % Change in EBIT These ideas of financial leverage generally differ from the ideas held in Europe about the definition of the concept and, therefore, its usage as a financial term. While most people in the English speaking world use financial leverage to talk about a common practice of using debt to buy assets to try to increase returns on investments in the face of risk (this is considered by some to be unsound practices), in Spain the term financial leverage is used in a more academic way to talk about the situation or current state of a business given the cost to repay debt and the ratio between liabilities and net assets called a debt ratio

To leverage or not to leverage?
 Leverage can be explained as the effect created when you borrow money to purchase an asset. When a company wants to buy an asset that cost, for example, $100,000 they have two options: use their own money or use part of their own money and borrow the rest. If it chooses the first option, they will own 100% of the asset.

If the asset increases in value by, for example, 25%, their Return on Equity (ROE) would be +25% and the value of the asset would be $125,000 which means it would make $25,000 profit. The same thing happens in an opposite situation. If the asset decreases in value by 25%, they would lose $25,000 (ROE=-25%).

If it chooses the second option and borrows half of the money, $50,000, to pay for the asset, the leverage factor will have a multiplier effect on gains or losses. If the value of the asset increases by 25%, its value would be $125,000. The company still needs to pay back the $50,000 it borrowed from the bank and has $75,000 remaining. That means there was a profit made of $25,000, or a 50% Return on Equity (ROE). However, the same thing can happen conversely if the asset decreases its value by 25%; its value would now only be $75,000. The company still needs to pay back the $50,000 it borrowed and is left with $25,000. This means its Return on Equity would be -50%. As one can see, using debt instead of equity to buy assets has a multiplier effect on either the gains or losses perceived as compared to gains or losses from only using equity.

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