Financial Leverage Formula

The Financial Leverage Formula refers to the mathematical expression that allows firms to compute their dependence on borrowing and their ability to generate revenue from its debt or borrowing. Calculating this is a simple total debt to shareholders equity ratio.

Debt can be borrowing funds from banks through a loan or issuing equity in a market to get the funds. These funds help a company grow, generate revenue, and increase its share price and market standard, leading to increased fund performance and the potential to give a high rate of return on investments.

Financial leverage formula allows first to find out how capably firms can use their borrowed capital as a funding source. Financial leverage, as the name suggests, tells companies about their opportunities to grow using their borrowed assets and lets them plan to leverage the funds. Though the borrowed funds seem to be a liability, it helps build the equity base of the companies. The formula to calculate financial leverage is as follows:

Financial Leverage Formula = Total Debt / Shareholder’s Equity

Here,

Total Debt = Short Term Debt + Long Term Debt

The above formula is a debt-to-equity ratio, which is the most commonly used mathematical equation to figure out the leverage. However, there are other formulas as well using which one can use to compute the financial leverage ability – Debt-to-EBITDA Ratio and Equity Multiplier.

• Debt-to-EBITDA = Total Debt/EBITDA

Where,

EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization

• Equity Multiplier = Total Assets/Total Equity

Using financial leverage formula in financial management is beneficial for both the companies as well as investors. Companies utilize this amount to invest in their business operations and use the debt as their resource to grow. Financing assets using this fund increases the shareholder value, given the progress they aim at.

On the contrary, this amount allows investors to have an idea of how much to trust a company. In turn, they learn about the returns to be expected from the investments they make into the company and its assets. The investors invest in options, margin accounts and other various instruments to leverage their investments the best way.

The most significant ways of assessing the capability of a company or business to utilize the debt to build equity and progress is by figuring out the Degree of Financial Leverage (DFL). To compute it in terms of degree, the following formula can help:

DFL = % change in Earnings per share (EPS)/ % change in EBIT

Where,

EBIT is the Earnings Before Interest and Taxes.

Let us see how companies use financial leverage formula with examples to understand them better:

Example #1

Let us see an example to understand the calculation of the financial leverage formula.

Suppose Star Logistic Pvt. Ltd. needs to know its financial leverage. The company had a debt of $100,000 and shareholder's equity of $40,000. The financial leverage calculation will be: -

• The result will be:-

So, from the above analysis, the financial leverage value will be 2.5.

Example #2

Apple Pvt. Ltd. purchased machinery at $100,000 in cash. By using that machinery, the company generated revenue of $150,000. At the same time, another company called Kiwi Pvt. Ltd. took out a loan to buy the same type of machinery to generate revenue of $150,000. Kiwi Pvt. Ltd. used financial leverage to generate income but faced a loss of $300,000.

Financial leverage helps a company enhance earnings and tax treatment to reduce the net cost of borrowing as interest expense is tax-deductible. There is below a highlight of financial leverage: –

• If the value of financial leverage is higher, more debt usage increases the company's expense in processing fees and interest paid on it. It may affect the EPS and profitability of a company.
• Whereas, if the value of financial leverage is low, a company issues many equity and financial securities to raise funds for business growth. At the same time, the risk is also increasing as the risk-on market is high, and the market is too volatile.
• Financial risk also helps find the company's actual financial position and risk associated with its business.
• Financial leverage lets the investor know the company's credibility and the risk involved in a monetary transaction.  And helps to see the return on investment and helps to calculate potential returns.

Example #3

Let us see an example of financial leverage calculation. Suppose below is the Rolta Pvt. Ltd. balance sheet for 2016, 2017, and 2018.

With the help of the above-given balance sheet, we have gathered the below information: -

• Current Debt = 6,412 for 2016, 7,412 for 2017 and 9,629 for 2018
• Total Debt = 13,437 for 2016, 17,286 for 2017 and 21,230 for 2018
• Total Equity = 48,461 for 2016, 52,816 for 2017 and 63,986 for 2018

Using the above information, let us calculate the financial leverage for all the years.

So, the financial leverage calculation for 2016: -

Financial leverage calculation for 2017: -

Financial leverage calculation for 2018: -

So, financial leverage increased from 28% in 2016 to 33% in 2017 to 34% in 2018.

The uses of the financial leverage equation are as follows: -

• One may use financial leverage in corporate capital structuring.
• It helps in taxation by reducing the net cost of borrowing as interest expense is tax-deductible.
• It helps to know the financial risks of the company.
• Financial leverage also helps in making major decisions for a company.

The financial leverage equation is very important and sensitive as borrowing funds helps a company grow and increase profit. Still, the risk is also involved, leading to the company's potential loss. Therefore, needs two main factors before considering the value of leverage: the industry's economic condition and the type of industry.