What Is Financial Leverage, and Why Is It Important? #NewsUnitedStates

What Is Financial Leverage?

Financial leverage is the concept of using borrowed capital as a funding source. Leverage is often used when businesses invest in themselves for expansions, acquisitions, or other growth methods.

Leverage is also an investment strategy that uses borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment.

Understanding Financial Leverage

Leverage is using debt or borrowed capital to undertake an investment or project. It is commonly used to boost an entity’s equity base. The concept of leverage is used by both investors and companies:

• Investors use leverage to significantly increase the returns that can be provided on an investment. They leverage their investments using various instruments, including options, futures, and margin accounts.
• Companies can use leverage to finance their assets. In other words, companies can use debt financing to invest in business operations to influence growth instead of issuing stock to raise capital.

Investors who are not comfortable using leverage directly have a variety of ways to access leverage indirectly. They can invest in companies that use leverage in the ordinary course of their business to finance or expand operations—without increasing their outlay.

The point and result of financial leverage is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out. When one refers to a company, property, or investment as “highly leveraged,” it means that the item has more debt than equity.

How to Calculate Financial Leverage

There is an entire suite of leverage financial ratios used to calculate how much debt a company is leveraging in an attempt to maximize profits. Here are several common leverage ratios.

Debt Ratio

You can analyze a company’s leverage by calculating its ratio of debt to assets. This ratio indicates how much debt it uses to generate its assets. If the debt ratio is high, a company has relied on leverage to finance its assets. A ratio of 1.0 means the company has $1 of debt for every $1 of assets. If it is lower than 1.0, it has more assets than debt—if it is higher than 1.0, it has more debt than assets.

$\begin{aligned}&\textbf{Debt Ratio }\mathbf{=}\textbf{ Total Debt }\mathbf{\div}\textbf{ Total Assets}\end{aligned}$​Debt Ratio = Total Debt ÷ Total Assets​

Keep in mind that when you calculate the ratio, you’re using all debt, including short- and long-term debt vehicles.

Debt-to-Equity (D/E) Ratio

Instead of looking at what the company owns, you can measure leverage by looking strictly at how assets have been financed. The debt-to-equity (D/E) ratio is used to compare what the company has borrowed to what it has raised from private investors or shareholders.

$\begin{aligned}&\textbf{Debt-to-Equity (D/E) Ratio }\mathbf{=}\textbf{ Total Debt }\mathbf{\div}\textbf{ Total Equity}\end{aligned}$​Debt-to-Equity (D/E) Ratio = Total Debt ÷ Total Equity​

A D/E ratio greater than 1.0 means a company has more debt than equity. However, this doesn’t necessarily mean a company is highly leveraged. Each company and industry typically operates in a specific way that may warrant a higher or lower ratio.

For example, start-up technology companies may struggle to secure financing and must often turn to private investors. Therefore, a debt-to-equity ratio of .5 ($1 of debt for every $2 of equity) may still be considered high for this industry.

Debt-to-EBITDA Ratio

You can also compare a company’s debt to how much income it generates in a given period using its Earnings Before Income Tax, Depreciation, and Amortization (EBITDA). The debt-to-EBITDA ratio indicates how much income is available to pay down debt before these operating expenses are deducted from income.

A company with a high debt-to-EBITDA carries a high degree of debt compared to what the company makes. The higher the debt-to-EBITDA, the more leverage a company is carrying.

$\begin{aligned}&\textbf{Debt-to-EBITDA Ratio}\\&\qquad\mathbf{=}\textbf{ Debt }\mathbf{\div}\textbf{ Earnings Before Interest, Taxes, Depreciation, and Amortization}\end{aligned}$​Debt-to-EBITDA Ratio= Debt ÷ Earnings Before Interest, Taxes, Depreciation, and Amortization​

An issue with using EBITDA is that it isn’t an accurate reflection of earnings. This is because it doesn’t include expenses that must be accounted for. It is a non-GAAP measure some companies use to create the appearance of higher profitability.

Equity Multiplier

Debt is not directly considered in the equity multiplier; however, it is inherently included, as total assets and total equity each have a direct relationship with total debt.

The equity multiplier attempts to understand the ownership weight of a company by analyzing how assets have been financed. A company with a low equity multiplier has financed a large portion of its assets with equity, meaning they are not highly leveraged.

$\begin{aligned}\textbf{Equity Multiplier }\mathbf{=}\textbf{ Total Assets }\mathbf{\div}\textbf{ Total Equity}\end{aligned}$Equity Multiplier = Total Assets ÷ Total Equity​

DuPont analysis uses the equity multiplier to measure financial leverage. One can calculate the equity multiplier by dividing a firm’s total assets by its total equity. Once figured, multiply the total financial leverage by the total asset turnover and the profit margin to produce the return on equity.

For example, if a public company has total assets valued at $500 million and shareholder equity valued at $250 million, the equity multiplier is 2.0 ($500 million ÷ $250 million). This shows the company has financed half its total assets with equity.

But if it had $500 million in assets and equity of $100 million, its equity multiplier would be 5.0. Hence, larger equity multipliers suggest that further investigation is needed because there might be more financial leverage used.

Degree of Financial Leverage (DFL)

Fundamental analysts can also use the degree of financial leverage (DFL) ratio. The DFL is calculated by dividing the percentage change of a company’s earnings per share (EPS) by the percentage change in its earnings before interest and taxes (EBIT) over a period.

$\begin{aligned}\textbf{Degree of Financial Leverage }&\mathbf{=\%}\textbf{ Change in Earnings Per Share}\\&\mathbf{\div\ \%}\textbf{ Change in EBIT}\end{aligned}$Degree of Financial Leverage ​=% Change in Earnings Per Share÷ % Change in EBIT​

The goal of DFL is to understand how sensitive a company’s EPS is based on changes to operating income. A higher ratio will indicate a higher degree of leverage, and a company with a high DFL will likely have more volatile earnings.

Consumer Leverage Ratio

The formulas above are used to evaluate a company’s use of leverage for its operations. However, households can also use leverage. By taking out debt and using personal income to cover interest charges, households may also use leverage.

Consumer Leverage is derived by dividing a household’s debt by its disposable income. Households with a higher calculated consumer leverage have high degrees of debt relative to what they make and are, therefore, highly leveraged.

$\begin{aligned}&\textbf{Consumer Leverage }\mathbf{=}\textbf{ Total Household Debt }\mathbf{\div}\textbf{ Disposable Income}\end{aligned}$​Consumer Leverage = Total Household Debt ÷ Disposable Income​

Consumers may eventually find difficulty in securing loans if their consumer leverage gets too high. For example, lenders often set debt-to-income limitations when households apply for mortgage loans.

Financial ratios hold the most value when compared over time or against competitors. Be mindful when analyzing leverage ratios of dissimilar companies, as different industries may warrant different financing compositions.

Advantages and Disadvantages of Financial Leverage

Advantages

Some investors and traders use leverage to amplify profits. Trades can become exponentially more rewarding when your initial investment is multiplied by additional upfront capital. Using leverage also allows you to access more expensive investment options that you wouldn’t otherwise have access to with a small amount of upfront capital.

Leverage is best used in short-term, low-risk situations where high degrees of capital are needed. For example, during acquisitions or buyouts, a growth company may have a short-term need for capital, resulting in a strong mid-to-long-term growth opportunity.

As opposed to using additional capital to gamble on risky endeavors, leverage enables smart companies to execute opportunities at ideal moments with the intention of exiting their leveraged position quickly.

Disadvantages

If investment returns can be amplified using leverage, so too can losses. Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment.

On top of that, brokers and contract traders often charge fees, premiums, and margin rates and require you to maintain a margin account with a specific balance. This means that if you lose on your trade, you’ll still be on the hook for extra charges.

Leverage also has the potential downside of being complex. Investors must be aware of their financial position and the risks they inherit when entering into a leveraged position. This may require additional attention to one’s portfolio and contribution of additional capital should their trading account not have a sufficient amount of funding per their broker’s requirement.

Pros

• Can amplify returns, creating potential for big profits

• Reduces barriers to entry by allowing investors to access more expensive trading opportunities

• A strategic way for companies to meet short-term financing needs for acquisitions or buyouts

Cons

• Can amplify downside by creating potential for losses and increased debt

• More expensive than other types of trading

• Results in fees, margin rates, and contract premiums regardless of the success of the trade

• More complex as trading may require additional capital and time based on portfolio needs

Financial Leverage vs. Margin

Margin is a special type of leverage that involves using existing cash or securities as collateral to increase one’s buying power in financial markets. Margin allows you to borrow money from a broker for a fixed interest rate to purchase securities, options, or futures contracts in anticipation of receiving substantially high returns.

You can use margin to create leverage, increasing your buying power by the total amount in your margin account. For instance, if you require $1,000 in collateral to purchase $10,000 worth of securities, you would have a 1:10 margin or 10x leverage.

Example of Financial Leverage

Consider a company formed with a $5 million investment from investors. This equity is the money the company can use to operate.

If the company uses debt financing and borrows $20 million, it now has $25 million to invest in business operations and more opportunities to increase value for shareholders. However, it would have a high debt-to-equity ratio. Depending on its industry and its average ratios, a ratio this high could be either expected or concerning.

These types of leveraged positions occur frequently. For example, since 2016, Apple (AAPL) has issued $4.7 billion of Green Bonds. By using debt funding, Apple could expand low-carbon manufacturing and create recycling opportunities while using carbon-free aluminum.

This type of leverage strategy can work when more revenue is generated than the debt created by issuing bonds.

What Is Financial Leverage?

Financial leverage is the strategic endeavor of borrowing money to invest in assets. The goal is to have the return on those assets exceed the cost of borrowing the funds. The goal of financial leverage is to increase profitability without using additional personal capital.

What Is an Example of Financial Leverage?

An example of financial leverage is buying a rental property. If the investor only puts 20% down, they borrow the remaining 80% of the cost to acquire the property from a lender. Then, the investor attempts to rent the property out, using rental income to pay the principal and debt due each month. If the investor can cover its obligation by the income it receives, it has successfully utilized leverage to gain personal resources (i.e., ownership of the house) and potential residual income.

How Is Financial Leverage Calculated?

Financial leverage can be calculated in several different ways. There is a suite of financial ratios referred to as leverage ratios that analyze the level of indebtedness a company experiences against various assets. The two most common financial leverage ratios are debt-to-equity (total debt/total equity) and debt-to-assets (total debt/total assets).

What Is a Good Financial Leverage Ratio?

In general, a debt-to-equity ratio greater than one means a company has decided to take out more debt as opposed to finance through shareholders. Though this isn’t inherently bad, the company might have greater risk due to inflexible debt obligations. The company must be compared to similar companies in the same industry or through its historical financials to determine if it has a good leverage ratio.

Why Is Financial Leverage Important?

Financial leverage is important as it creates opportunities for investors and businesses. That opportunity comes with high risk for investors because leverage amplifies losses in downturns. For businesses, leverage creates more debt that can be hard to pay if the following years present slowdowns.

The Bottom Line

There are several ways that individuals and companies can boost their equity base. Financial leverage is one of these methods. For businesses, financial leverage involves borrowing money to fuel growth. It allows investors to access certain instruments with fewer initial outlays.

Because of the risks of using leverage, it’s important to compare the advantages and disadvantages and determine whether financial leverage truly makes sense for your financial circumstances and goals.