Individuals or businesses purchase assets or collect funds to build projects by borrowing money from private lenders or banks. Such lending practice is known as financial leverage. Business owners get the opportunity to acquire capital or funds at short notice and are mostly helpful in business expansion.
Let us dive deeper into this article to get a clear understanding of financial leverage, its formulas, types and ratios applied in the business.
What Is Financial Leverage?
Financial leverage is a processwherebusinesses or individuals use loans to fund projectsor acquire extra assets for the business. After the project or asset acquisition is complete, the borrower pays back the principal sum with the interest amount. The purpose of implementing financial leverage is different for different entities. In various scenarios, the debt provider puts a limit on the risk it is ready to take, indicating a specific limit on the leverage that would be allowed.
What is Leverage in Financial Management?
Leverage in financial managementis atype of investment where money borrowedis usedto get maximum returnon investment or acquire additional assets for business expansion. Businesses create such debts by borrowing capital from different lenders and promising them to pay with additional interest after a specific time.
In the financial management process of a company, the use of leverage acts as the reason to increase asset values, increase the shareholders' value and acquire new equipment. Nonetheless, individuals not wanting to get themselves involved in leveraging can invest in a business that uses leverage methods to complete organisational activities. Asset value and loan interest are the two main factors considered in this aspect.
Significance of Financial Leverage
The aspect of financial leverage is significant since itempowers both individual investors and organisationsto tap intoinvestment opportunitiesthat may surpass their existing cash reserves. Although this strategy entails a level of risk, it has the potential to foster business expansion, thereby generating additional employment opportunities and stimulating economic activity.
Furthermore, it can enable nonprofit institutions such as hospitals and universities, which frequently contend with limited regular cash flow, to expand their operations and extend their reach to a larger audience.
Types of Leverage In Financial Management
There are three main types of leverage used in the financial management process of an organisation. They are discussed as follows.
- Financial Leverage
This is the total debt a business acquires to fulfil different financial purposes. In the financial statements, this type of spoof leverage is represented under the list of liabilities. Financial leverage helps you to continue with your investments even if the business does not have enough cash. Equity financing is the most preferred option in this case, as it allows you to raise money without liquidating your ownership.
- Operating Leverage
Operating leverage pertains to the combination of fixed and variable costs associated with delivering products and services. Fixed costs remain consistent, independent of output levels, necessitating payment whether a business is profitable or incurring losses. The assessment of operating leverage involves calculating the ratio between fixed and variable costs. If fixed expenses outweigh variable ones, a business exhibits high operating leverage. While this can enhance returns, excessive reliance on it escalates financial risk.
- Combined Leverage
This type of financial leverage accounts for the total risk of your business. Such leverage aggregates the effects of financial and operating leverage and presents a complete report of your business's financial position. Moreover, this leverage is generally used by capital-intensive companies that have the potential to expand but have low equity. Before applying combined leverage, always remember to study the market conditions and be sure of the future expenses of the business to avoid unnecessary risks.
Financial Leverage Ratio Formula
You can usemany financial ratiosto calculate your business's financial leverage. The common financial leverage ratios and formulas that you can implement are discussed below.
Debt to Equity Ratio
This ratio determines the total financial leverage of a business and shows the debt-to-equity proportion of the company. The result of this ratio helps the lenders, shareholders and management of the company to understand the risk level in the capital structure of the firm. The debt-to-equity ratio is calculated using this formula -
Debt to Equity (D/E) Ratio = Total Debt ÷ Total Equity
Debt to Capital Ratio
Debt to Capital ratio measures the financial leverage of a firm by comparing the debt of the business to its capital. Here, debts can be both short-term and long-term, and capital is the value of the total equity associated with debt and shareholders. The formula is -
Debt to Capital Ratio = Debt ÷ (Debt + Shareholder’s Equity)
Interest Coverage Ratio
This financial leverage ratio adds context to the liabilities of the business by providing data to the analysts on how well the business can service the existing debts. Companies generally try to keep this ratio 3 or higher, but it depends on the industry as well. The formula of this ratio is -
Interest Coverage Ratio = Operating Income ÷ Interest Expenses
Debt to EBITDA Ratio
With this ratio, the analysis of how well the business can pay off its debts and how likely it can default in payment is assessed. EBITDA is earnings before interest, tax, depreciation and amortisation. You can calculate this ratio using the following formula -
Debt to EBITDA Ratio = Debt ÷ EBITDA
Total Debt to Total Asset Ratio
As per this financial leverage ratio, you can understand the degree to which the assets of the business are funded by taking debts. The formula is -
Total Debt to Total Assets Ratio = Total Debts ÷ Total Assets
Equity Multiplier
The calculation of this ratio helps stakeholders of a firm understand the weightage of ownership in the business by analysing the way of financing assets. For a low equity multiplier, the business is considered to be financed largely with equity and is not considered a highly leveraged business. You can use this formula for calculation-
Equity Multiplier = Total Assets ÷ Total Equity
Degree of Financial Leverage
The degree of financial leverage or DFL is a financial leverage ratio that measures earnings per share or EPS of a business with fluctuation in operating income due to the change in capital structure. This ratio mainly denotes that higher financial leverage means the earnings will be volatile.
The value of DFL is important to assess the valuation of financial leverage and determine how businesses can streamline processes to reduce monetary obligations. However, if the firm operates in such a sector where operating income is volatile, it is always recommended to limit debts to a manageable and easy level.
The formula used to calculate this ratio is -
DFL = % change in EPS ÷ change in EBIT
Or,
DFL = EBIT ÷ (EBIT - Interest)
*EBIT means Earnings Before Interest and Tax
Difference Between Operating Leverage and Financial Leverage
The differences between operating and financial leverage are represented in the table below.
| Category | Financial Leverage | Operating Leverage |
| Meaning | This is the ability of a business to use its capital to earn better returns as well as reduce tax liability. | This is the ability of a company to use the existing fixed costs of the firm to generate higher returns. |
| Measurement | It measures the financial risk within the company. | It measures different organisational operating risks. |
| Impact | A higher degree of financial leverage denotes higher risk in the business and vice versa. | Higher operating leverage indicates higher operating risk for the business and vice versa. |
| Preference | Highly preferred. | No preferred too much. |
Financial Leverage Example
Here is an example that will help you understand how financial leverage works.
Suppose Company XYZ wants to acquire a valuable asset worth Rs. 10,00,000. Now, the company faces a choice between two methods of financing: equity or debt.
If Company XYZ opts for the equity route, it means they are willing to give away a part of their company to own the asset. In this case, they will fully own the asset from the beginning, and there won't be any interest payments involved.
If the value of the asset appreciates by 40%, the asset's new value would be Rs. 14,00,000, resulting in a profit of Rs. 4,00,000 for the company. Conversely, if the asset's value depreciates by 40%, the asset would be worth Rs. 6,00,000, leading to a loss of Rs. 4,00,000 for the company.
Alternatively, Company XYZ could choose a different path by financing the asset using a combination of common stock and debt in a 50/50 ratio. In this case, if the asset appreciates by 40%, its value would also become Rs. 14,00,000. It can then use the profit to pay off the debt faster and own the asset completely.
Limitations of Financial Leverage
There are a few limitations to using the financial leverage method in your business. They are:
- There is no guarantee of returns on investment. If anything goes haywire, you still have to repay the amount you borrowed.
- If you default or fall behind in paying the loan or credit, it can damage your credit capability among lenders.
- Borrowing money from relatives or family can strain personal relationships if things in the business don't work out.
- If you borrow money against your personal asset, such as a house or car, there is a risk you will lose it if you default.
Advantages of Financial Leverage
Even if the risks of financial leverage are high, there are some advantages to this method. They are:
- If you borrow money, you can invest it in the business sooner or later.
- Investing the borrowed money can help in the growth of your business as well as your wealth for a longer period.
- Your investments also have the potential to improve your quality of life.
Conclusion
Introducing financial leverage in your business can help you grow your business and wealth faster. The borrowed money can be utilised to invest in new projects, fund ongoing projects or grow the capital structure of the firm, helping you get higher returns after a certain tenure.
However, before introducing this method in your firm, make sure to have a chat with professionals about how effectively this method can be implemented in the business and how you can grow your business without many risks.
Frequently Asked Questions
What is financial leverage and its formula?
Financial leverage is the utilisation of loans by firms or individuals to fund initiatives or buy more assets for the business. The formula of financial leverage is -
Financial Leverage = Total Debt ÷ Shareholder's Equity
What does financial leverage measure?
Financial leverage measures the relation between the equity and debt of the company.
What is a good degree of financial leverage?
If you have a financial leverage ratio lower than 1, it is considered good leverage.
What is the financial leverage ratio?
Financial leverage ratio is a set of ratios that points to a company's financial leverage in terms of its equities, liabilities and assets.
Can the degree of financial leverage be negative?
Yes. The degree of financial leverage can be negative for abscess. This is because it shows the return on total assets to be less than the return on stockholder's equity.
