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 or borrowed capital in order to undertake an investment or project. It is commonly used as a way 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 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.

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. Several common leverage ratios are listed below.

Total-Debt-to-Total-Assets Ratio

A company can analyze its leverage by seeing what percent of its assets have been purchased using debt. A company can subtract the total debt-to-total-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.

Total-Debt-to-Total-Assets 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, it 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 compared to what it has raised from private investors or shareholders.

Debt-to-Equity Ratio = Total Debt ÷ Total Equity

A D/E ratio greater than one 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 may still be considered high for this industry compared.

Debt-to-EBITDA Ratio

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 is controllable. That's why it is common to use EBITDA instead of net income.

A company with 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.

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

Equity Multiplier

Debt is not directly considered in the equity multiplier. But it is inherently included as total assets and total equity each has 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.

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, 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)

Fundamental analysis uses the degree of financial leverage (DFL). 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.

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 by companies that 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 leveraged.

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.

Advantages and Disadvantages of Financial Leverage

Advantages

Investors and traders primarily use leverage to amplify profits. Winners 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 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 leveraged position quickly.

Disadvantages

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 often charge fees, premiums, and margin rates. 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 equity per their broker's requirement.

Financial 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 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.

Examples of Financial Leverage

A company was formed with a $5 million investment from investors, where the equity in the company is $5 million, which 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 opportunities 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 the company's growth.

These types of leveraged positions occur all the time in financial markets. For example, Apple (AAPL) issued $4.7 billion of Green Bonds for the third time in March 2022. By using debt funding, Apple could expand low-carbon manufacturing and create recycling opportunities while using carbon-free aluminum. A strategy like this works when greater revenue is generated compared to the cost of the bonds.

The Bottom Line

There are several ways that individuals, and companies can boost their equity base. Financial leverage is one of these methods. Financial leverage involves borrowing money to fuel growth. This capital can come from banks and lenders or from shareholders. While borrowing money may allow for growth by, for example, allowing entities to purchase assets, there are risks involved. As such, it's important to compared the advantages and disadvantages, and determine whether financial leverage truly makes sense.