Financial Leverage

Financial leverage is an indicator which shows the proportion of debt over equity/capital or assets. It is the use of debt to buy more assets. As the proportion of debt to assets increases, it may higher the risk for getting return on equity and hence financial leverage will also increase. However, excessive amount of financial leverage may increase the chances of failure and it will difficult for business to repay the debt. But, Financial leverage will be favorable when debt can be putted such that it will give higher return than the interest expenses associated with the debt.

Leverage Ratio

Leverage ratio is a kind of financial ratio that indicate the level of debt incurred by a business against several other accounts in its balance sheet, income statement or cash flow statement. These ratios provides an indication of how the company's assets and business operations are financed using debt or equity.

Common Measures of Leverage Ratios

Debt - Asset Ratio = Total Debt / Total Asset
Debt - Equity Ratio = Total Debt / Total Equity
Debt - Capital Ratio = Total Debt / Total (Debt + Equity)
Debt - EBITDA Ratio = Total Debt / Earning before Income Tax Deprecation & Amortization (EBTIDA)
Asset - Equity Ratio = Total Assets / Total Equity

Factors affecting Financial Leverage

Financial Liability : Excessive borrowing in the form of debts may led to financial liabilities for the company.
Financial Decisions : The financial leverage decisions is a part of the company's financial strategy and mostly planned by the Directors.
Interest Rates : This type of borrowing is payable with the interest which is generally high.
Stability of the firms : Firms stability is most important for financial decisions because it shows the position of the firms and its capacity to bear the risk.
Return on Assets : Returns is estimated to find out whether the company will be able to generate higher profits or not.
Fixed Financial Costs : This mean, it create a fixed financial burden in the form of interest over the company.

Advantages of Financial Leverage

Magnification of shareholders profit
Improvement in credit rating
Capturing Economies of scale
Increased Free cash
Powerful access to Capital
Ideal for acquisitions, buyout
Tax Relaxations

Disadvantages of Financial Leverage

High Risk
More costly
Adverse Result
High Rate of Interest
May lead to Bankruptcy

Examples

XYZ Company uses ₹10,00,000 of its own cash to buy a factory, which generates ₹150,000 of annual profits. The company is not using financial leverage at all, since it incurred no debt to buy the factory.
Company uses ₹100,000 of its own cash and a loan of ₹900,000 to buy a similar factory, which also generates a ₹150,000 annual profit. Company is using financial leverage to generate a profit of ₹150,000 on a cash investment of ₹100,000, which is a 150% return on its investment.

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