Monday, 18 February 2013

Determining Financial Leverage with Example


Financial Leverage Ratio Formula

Financial leverage is computed as:

Financial Leverage Ratio = Assets

                                           Equity
A higher ratio implies that the assets of the company are financed primarily through debt. A financial leverage ratio of 2.0 reflects that the liabilities of the company are equal to the equity. A ratio of greater than 2.0 implies that liabilities are larger than equity and a ratio of less than 2.0 implies higher equity than the liabilities of the company.

Financial leverage has a magnifying effect on earnings. When the earnings are positive, a marginal percentage change in revenue translates to a greater percentage change on earnings per share or on return on equity measures.

Correspondingly, however, as debt represents fixed costs, leverage also has a magnifying effect on losses. If the financial leverage ratio, for example, is 3.0 and the company experiences a loss, it will experience a greater percentage loss in net income than the percentage decline in revenue. An increase in the financial leverage ratio, therefore, represents not only increased opportunity for leveraging returns but also an increased risk of magnifying any losses and of its inability to meet long-term debt. In summary, the potential loss or profit being magnified belongs to the stockholder. So if a firm is profitable, the benefit realized from a high net income with a high financial leverage ratio goes to stockholders in the income statement, the financial leverage ratio must be adjusted accordingly. 

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