Financial Leverage is essentially a measure of how much debt a company carries, relative to shareholders’ equity
Financial Leverage Formula
Financial Leverage = Assets /Shareholders’ Equity
Think of it like a Mortgage – a homebuyer who puts Rs. 200,000 down on a Rs. 1,000,000 house has a financial leverage ratio of 5. For every Rupee in Equity, the buyer has Rs. 5 in assets.
The same holds true for companies. In 2008, a retailer like Trent has a financial leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total assets. (It borrowed the other Rs. 1.1.)
Financial Leverage is something you need to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster. Look at the kind of business a firm is in. If it’s fairly steady, a company can probably take on large amounts of debt without too much risk because there’s only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments. On the flip side, be very wary of a high finacial leverage ratio if a company’s business is cyclical or volatile. Because interest payments are fixed, the company has to pay them whether business is good or bad.
Calculating Financial Leverage
Return on Equity is simply calculated by dividing Total Assets by Shareholders’ Equity. Both Total Assets and Shareholders Equity can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Shareholders Equity is simply the difference between Total Assets and Total Liabilities – the assets that the business has generated. Shareholder equity is an accounting term that represents the assets created by the retained earnings of the business and the paid-in capital of the owners. Total Assets is simply all the property owned by a company. Total assets include current assets; fixed assets such as buildings, plant and machinery, and other assets such as licenses and goodwill.
Rough benchmarks for analysing a firm’s Financial Leverage
A financial leverage ratio of 2.1 is fairly conservative, even for a fast growing retailer. Its when we see ratios of 4, 5 or more that companies start to get really risky.
However, financial firms and banks have a much larger asset base relative to equity. The average bank has a financial leverage ratio in the range of 12 to 1 or so, as compared to 2-to-1 or 3-to-1 for the average company.
You may also like to learn more on other financial strength measures, as below.