Financial Leverage Ratio

The financial leverage ratio, also called the equity multiplier, is calculated as follows:

The financial leverage ratio indicates the amount of debt a firm is using to finance its assets. The more debt the company has, the higher its financial leverage ratio will be. As a company increases its debt, it is incurring more fixed charges of interest that must be paid. The more fixed charges in interest the company has, the less income it will have available for distribution. If a company has a high financial leverage ratio in combination with high volatility of sales or operating profit (high volatility means that they change greatly from period to period), the risk is greater that the company will not be able to service its debt and will default on it.

Borrowing money to finance assets will cause total assets to increase while total equity remains unchanged. Since the financial leverage ratio is calculated as total assets divided by total equity, the company’s financial leverage ratio will increase as more money is borrowed to finance additional assets.

On the other hand, issuing equity to finance assets will cause total assets and total equity to increase by the same absolute amount. Since beginning total assets are greater than beginning total equity, the proportional increase in total assets will be less than the proportional increase in total equity. Since the numerator of the financial leverage ratio will increase less, proportionately, than the denominator will, the result will be a decrease in the financial leverage ratio.

A company with financial leverage is said to be “trading on the equity.” “Trading on the equity” is simply a term that means the company is using financial leverage (debt) in an effort to achieve increased returns. Trading on the equity, or financial leverage, may or may not be successful.

• If a leveraged company’s return on assets is greater than its after-tax cost of debt, and therefore return on common equity is higher, it is said to be successfully trading on the equity, and its common shareholders will benefit.
• If a leveraged company’s return on assets is less than its after-tax cost of debt, it is said to be unsuccessfully trading on the equity, and its common shareholders will be hurt.

Remember that “trading on the equity” is only a term that is used to mean that a company is borrowing money to invest in assets. The company is borrowing to invest because it expects the investment to earn a greater return than the company will pay in interest, and thus the company’s profits will increase as a result of its borrowing to invest. In fact, by borrowing a portion of the funds it invests, a company can greatly increase its rate of return on the amount of its own funds that it has invested.

Example of the effect of financial leverage: A company is planning a $1,000,000 capital investment project that it expects to return 15% annually after tax. At a return rate of 15%, the net return expected on the investment after tax is $150,000 per year.

The company borrows half of the investment amount, or $500,000, at an interest rate of 6% after tax and thus pays interest after tax of $30,000 per year. It will have invested $500,000 of its own funds. If the expected profit materializes, the company will earn $150,000 minus $30,000 interest each year on the investment, for a net annual after-tax return of $120,000 annually on a $500,000 investment of its own funds. Until such time as the principal needs to be repaid, that represents a 24% return on its $500,000 investment.

Thus, the return from borrowing to invest can actually be greater than just the difference between the investment return (here 15%) and the interest rate on the borrowed funds (here 6%).

However, as stated above, trading on the equity may not always be so successful. Because the borrowed principal must be repaid along with interest, the company assumes risk by borrowing. The company is required to repay the obligation whether or not the expected return materializes. If the actual return is lower than expected, the repayment of the principal and interest will need to come from cash flow generated by other projects. Any loss on the company’s investment will be magnified by the debt, just as a positive return is magnified by the debt. Financial leverage has the effect of magnifying both profits and losses.

Comparing the company’s return on assets with its after-tax cost of debt can give an analyst some insight into whether or not the company’s management is using financial leverage successfully.