What Is Financial Leverage, and Why Is It Important?

What Is Financial Leverage?

Financial leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment.

Leverage can also refer to the amount of debt a firm uses to finance assets.

Understanding Financial Leverage

Leverage is the use of debt (borrowed capital) in order to undertake an investment or project. The result 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 item has more debt than equity.

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 lever their investments by using various instruments, including options, futures, and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.

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 normal course of their business to finance or expand operations—without increasing their outlay.

Calculating 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. Several common leverage ratios are listed below.

Debt-to-Assets Ratio

Debt-to-Assets Ratio = Total Debt / Total Assets

A company can analyze its leverage by seeing what percent of its assets have been purchased using debt. A company can subtract the debt-to-assets ratio by 1 to find the equity-to-assets ratio. If the debt-to-assets ratio is high, a company has relied on leverage to finance its assets.

Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Debt / Total Equity

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

A debt-to-equity ratio greater than one means a company has more debt than equity. However, this doesn't necessarily mean a company is highly levered. Each company and industry will typically operate 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 may still be considered high for this industry compared.

Debt-to-EBITDA Ratio

Debt-to-EBITDA = Total Debt / Earnings Before Interest, Taxes, Depreciation, and Amortization

A company can also compare its debt to how much income it makes in a given period. The company will want to know that debt in relation to operating income that is controllable; therefore, it is common to use EBITDA instead of net income. A company that has a high debt-to-EBITDA is carrying a high degree of weight compared to what the company makes. The higher the debt-to-EBITDA, the more leverage a company is carrying.

Equity Multiplier

Equity Multiplier = Total Assets / Total Equity

Although debt is not directly considered in the equity multiplier, it is inherently included as total assets and total equity each has direct relationships 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 levered.

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, one multiplies the financial leverage with the total asset turnover and the profit margin to produce the return on equity.

For example, if a publicly traded company has total assets valued at $500 million and shareholder equity valued at $250 million, then the equity multiplier is 2.0 ($500 million/$250 million). This shows the company has financed half its total assets by equity. Hence, larger equity multipliers suggest more financial leverage.

Degree of Financial Leverage (DFL)

Degree of Financial Leverage = % Change in Earnings Per Share / % Change in EBIT

Fundamental analysis uses the degree of financial leverage. The degree of financial leverage 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. The goal of DFL is to understand how sensitive a company's earnings per share 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

Consumer Leverage = Total Household Debt / Disposable Income

The formulas above are used by companies who are using leverage for their 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 levered. 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.

Advantages of Leverage

Investors and traders use leverage primarily to amplify profits. Winners can become exponentially more rewarding when your initial investment is multiplied by additional upfront capital. In addition, using leverage allows you to access more expensive investment options that you wouldn't otherwise have had access to with a smaller amount of upfront capital.

Leverage can be 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 that will result 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 levered position quickly.

Limitations of Leverage

If winning investments are amplified, so are losing investments. 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 will charge fees, premiums, and margin rates. Even 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 levered 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 equity per their broker's requirement.

Leverage vs. Margin

Margin is a special type of leverage that involves using existing cash or securities position as collateral used 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 the anticipation of receiving substantially high returns.

You can thus use margin to create leverage, increasing your buying power by the marginable amount—for instance, if the collateral required to purchases $10,000 worth of securities is $1,000 you would have a 1:10 margin (and 10x leverage).

Example of Leverage

A company was formed with a $5 million investment from investors, where the equity in the company is $5 million—this is the money the company can use to operate. If the company uses debt financing by borrowing $20 million, it now has $25 million to invest in business operations and more opportunity to increase value for shareholders.

An automaker, for example, could borrow money to build a new factory. The new factory would enable the automaker to increase the number of cars it produces and increase profits. Instead of being limited to only the $5 million from investors, the company now has five times the amount to use for growth of the company.

These types of levered positions occur all the time in financial markets. For example, Apple issued $4.7 billion of Green Bonds for the third time in March 2022. By using debt funding, Apple is able to expand low-carbon manufacturing, recycling opportunities, and use of carbon-free aluminum. If the strategy results in greater revenue than the cost of the bonds, Apple would have successfully levered its investment.