Financial Leverage: How Does It Work (+Examples)

Every company needs financial capital to operate optimally. The ability to raise financial capital so a company can reach its set financial goals is a skill every entrepreneur should have.

The majority of companies raise financial capital by issuing debt securities and by selling common stock. For a company to remain in a healthy financial state, it has to balance the risk and return implications of the debt and equity that make up its capital structure.

Companies can grow faster and operate at a more efficient level if they use the power of financial leverage. Financial leverage allows them to control a greater amount of assets through acquired debts so the company can generate a higher return on investment (ROI) for the company and investors.

In this article, you will learn what financial leverage is, how to measure financial leverage, examples of financial leverage, effects of financial leverage, and risks of financial leverage.

Let’s get started.

Definition Of Financial Leverage

Financial leverage is the use of a debt to acquire additional assets. It is also known as “leverage” or “trading on equity.” It involves the use of borrowed money to service the purchase of assets, with the expectation that the income or profit amassed from the purchased asset will exceed the cost of borrowing.

In this way, there would be enough financial room to repay the loan while enjoying the subsequent capital profits from the purchased asset. In many cases, the company providing the loan places a limit on how much risk it is willing to bear and indicates the extent of the leverage it would voluntarily give.

Financial leverage is used to increase the return on equity (the use of debt to buy more assets.) The sole aim of the loanee is to use debt to expand capital investments, increase his or her capital profit, and, consequently, use this increased income or profit to service the loan.

The provider of the debt determines the extent of leverage it allows and how much risk it is ready to take. There are two ways the debt provider does it, they are asset-backed lending and cash flow lending.

Asset-backed lending refers to a situation where the financial provider uses the purchased assets or some extra assets of the borrower as collateral until the loan is reimbursed.

A cash flow lending, however, is a risker venture. It refers to a situation where the lender trusts the general creditworthiness of the borrowing company and uses it as a form of collateral for the loan.

How Financial Leverage Is Measured

The company giving out the financial leverage determines the limit of risk it bears and indicates the extent of the leverage.

There are different ways through which financial leverage is measured, with some methods more common than others. Calculating the different ways for measuring financial leverage are small business bookkeeping basics that do not require lots of accounting expertise. They include debt-to-equity ratio, debt-to-capital ratio, debt-to-EBITDA ratio, and interest coverage ratio.

1. Debt-to-Equity Ratio

The debt-to-equity ratio is the most common way of measuring the financial leverage issued to a company. This method compares the proportion of debt to the borrowing company’s equity. It compares the financial loan given to the borrowing company’s ability to repay the loan.

This ratio indicates if the borrowing entity will have difficulties in meeting its debt obligations or not. Shareholders, lenders, and your company’s management use this ratio to understand the risk associated with the company’s capital structure.

Mathematically, the debt-to-equity ratio is equal to the total liabilities divided by the total equity

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

For example, the total liability of a payroll company is $5 million and the total equity amounts to $10 million.

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

Debt-to-Equity Ratio = $5 million / $10 million

Debt-to-Equity Ratio = 0.5

“Total Liabilities” refers to the full debt of the borrowing company. It includes both short-term debts with a maturity date below a year mark and long-term debts with longer maturity dates.

“Total Equity” refers to the total amount of shareholders’ investments in a company plus the amount of income retained after all expenses are deducted.

The other types of methods of calculating financial leverage are however not as common as the debt-to-equity ratio.

2. Debt-to-Capital Ratio

The debt-to-capital ratio compares the total debt of the borrowing company to the total capital of the company.

“Total Debt” consists of short-term payables and long-term debts while the “Total Capital” is the sum of the total debt and the equity.

Mathematically, the debt-to-capital ratio is equal to the total debt divided by the total capital.

Debt-to-Capital Ratio= Total Debt / Total Capital (Total Debt + Equity)

For example, an accounting software, AlphaBeta acquired a short-term loan of $50,000 and a long-term loan of $200,000. It has a common stock of $100,000, retained earnings of $120,000, and other equity of $80,000.

To calculate its debt-to-capital ratio, you have to first aggregate similar data together. First, we calculate the total debt.

Total Debt = Short term loan + Long term loan

Total Debt = $50,000 + $200,000

Total Debt = $250,000

Next, we calculate the total equity.

Total Equity = Common stock + Retained earnings + Other equity

Total Equity = $100,000 + $120,000 + $80,000

Total Equity = $300,000

Now let’s calculate the debt-to-capital ratio.

Debt-to-Capital Ratio= Total Debt / Total Capital (Total Debt + Equity)

Debt-to-Capital Ratio= $250,000 / Total Capital ($300,000 + $250,000)

Debt-to-Capital Ratio= $250,000 / $550,000

Debt-to-Capital Ratio= 0.45

3. Debt-to-EBITDA Ratio

“EBITDA” stands for “Earnings Before Income, Taxes, Depreciation, and Amortization.”

The debt-to-EBITDA ratio refers to the total debt of the borrowing company compared to the company’s total income before any recurring expenditures are paid.

Mathematically, the debt-to-EBITDA ratio is equal to the total debt divided by EBITDA.

Debt-to-EBITDA Ratio = Total Debt / EBITDA

For example, you are looking to evaluate a business internet service provider, iNet, ability to service its debts. The company has $1 million in total debt and its EBITDA is $5 million.

Debt-to-EBITDA Ratio = Total Debt / EBITDA

Debt-to-EBITDA Ratio = $1 million / $5 million

Debt-to-EBITDA Ratio = 0.5

4. Interest Coverage Ratio

The interest coverage ratio compares the “earnings before interest and taxes” (EBIT) of a borrowing company with its interest expenses.

Mathematically, the interest coverage ratio is equal to the EBIT divided by interest expense.

Interest Coverage Ratio = EBIT/Interest Expense

For example, an email marketing service for small businesses wants to calculate its interest coverage ratio. It records earnings before interest and tax of $64,000 and interest expense of $20,000.

Interest Coverage Ratio = EBIT / Interest Expense

Interest Coverage Ratio =$64,000 / $20,000

Interest Coverage Ratio = 3.20

Examples of Financial Leverage

To better understand the concept of financial leverage, it is essential to study different examples.

Example 1

If David makes use of his personal cash to purchase 40 houses for the full price of $500,000, he does not use financial leverage. However, if David wishes to purchase 40 houses worth $500,000 and borrows $300,000 to purchase them while using $200,000 of his money, he makes use of financial leverage.

The interest on the loan can be $50,000 per year and David would typically expect to finance the loan and interest from his profit from the investment.

Here is how David can measure his financial leverage using the debt-to-equity ratio.

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

Debt-to-Equity Ratio= $300,000 / $200,000

Debt-to-Equity Ratio= 1.5

Example 2

Let us assume that an order fulfillment service wishes to acquire an asset that costs $20,000,000. Rather than financing the investment with only equity, it opts for debt financing or, as we call it, financial leverage.

With this, the company can finance 50% of the cost from its equity and 50% from debt.

The company takes financial leverage of $10,000,000 to finance its $20,000,000 capital needed for asset expansion.

The equity is the other $10,000,000 that completes the $20,000,000 investment. A yearly interest of $2,000,000 accompanies the deal.

Here is how the order fulfillment service can measure its financial leverage using the debt-to-equity ratio.

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

Debt-to-Equity Ratio = $10,000,000 / $10,000,000

Debt-to-Equity Ratio = 1

Effects of Financial Leverage

Using our examples, the effects of financial leverage would be enumerated below.

Example 1

Let us assume that after one year the value of the 40 houses David bought increases by 20% (selling price of $600,000 minus the houses’ cost of $500,000). If he used only his personal cash to make a purchase, he would get a return of $600,000. This means that he gains $100,000 for himself alone. This is not financial leverage.

However, if he uses his own capital of $500,000 and takes a $300,000 financial leverage, he will be able to buy more units of houses (let’s say 30 more houses). After a year, the value of the houses increased by 20% ($960,000).

If his deal with the company that provided financial leverage was the principal plus annual interest of $30,000, he will pay $330,000 to his creditors and get $630,000 when he sells the houses. Deduct his initial cost of $500,000 and he makes a healthy profit of $130,000.

Let’s calculate David's return on equity using this formula for the 20% increase in the value of the asset.

Return on Equity = Current Equity Value / Equity Value at Beginning – 1

Return on Equity = (960,000 – 330,000) / 500,000 – 1

Return on Equity = 630,000 /500,000 – 1

Return on Equity = 26%

David’s return on equity is 26% when the value of the assets increases by 20%.

However, If a loss of 20% is made from selling the houses, David gets $400,000 to himself and suffers a loss of $100,000 (when he doesn’t use financial leverage). When he uses financial leverage of $300,000, even with a 20% loss (the house is now worth $640,000), his creditors still get their $300,000 initial loan and $30,000 annual interest. David, on the other hand, gets $310,000 and suffers a $170,000 loss.

Let’s calculate David's return on equity using this formula for the 20% decrease in the value of the asset.

Return on Equity = Current Equity Value / Equity Value at Beginning – 1

Return on Equity = (640,000 – 330,000) / 500,000 – 1

Return on Equity = 310,000 /500,000 – 1

Return on Equity = -38%

David’s return on equity is a negative -38% when the value of the assets decreases by 20%.

	Equity Value at the Beginning	Current Equity Value	Return on Equity
20% Increase in Asset Value	$500,000	S630,000	26%
40% Increase in Asset Value	$500,000	$790,000	58%
60% Increase in Asset Value	$500,000	$950,000	90%
20% Decrease in Asset Value	$500,000	$310,000	-38%
40% Decrease in Asset Value	$500,000	$150,000	-70%
60% Decrease in Asset Value	$500,000	-$10,000	-100%

A 20% increase in asset value means David records a 26% return on equity, a 40% increase in asset value means a 58% return on equity, and a 60% increase in asset value means a 90% return on equity.

Also, a 20% decrease in asset value means David records a 38% loss on equity, a 40% decrease in asset value means a 70% loss on his equity, and a 60% decrease in asset value means he loses all his equity.

In the case of a company, a 60% loss on equity means a company would be bankrupt and equity investors would not get anything.

Example 2

An online store specializing in selling vintage items seeks financial leverage worth $10,000,000 to purchase an asset worth $20,000,000. An interest of $2,000,000 per annum is placed on the loan.

In the case of an asset-backed loan and where the value of the purchased asset increases by 50%, the following effects will follow.

The value of the asset is now worth $30,000,000. The online store has to remit $12,000,000 to its creditor which includes the loan and interest on it. The store takes the remaining $18,000,000.

If the online store did not use financial leverage and purchased $10,000,000 worth of the asset, and the value increases by 50%, it will only gain $5,000,000.

In a situation where the online store loses 50% on the value of its assets, its store is still obliged to pay its creditor the $2,000,000 at the end of the year and the $10,000,000 loan amount. Where the loan is not paid as at the time stipulated on the contract, the company loses the assets used as security.

Considering both examples, it is clear that financial leverage only intensifies the effects of a profit or loss. Where a profit is made, financial leverage increases the profit amount, and where a loss is made, financial leverage leads to a higher loss amount.

Risks Of Financial Leverage

Financial leverage gives the effects of enhanced earnings for a company as well as heightened losses. Losses occur when the expense payments on a debt overwhelm the borrowing company. Here, the situation is so overwhelming that the returns from the asset are not sufficient to cover the loan.

In this situation, real financial problems emerge. Imagine a company facing financial difficulties suffering these enhanced losses inflated by financial leverage. A lot of things can go wrong and some of them would be discussed below.

1. Bankruptcy

When a company experiences loss with financial leverage, it could be pushed into bankruptcy due to the exaggeration of the losses suffered. The company becomes unable to fulfill its debt obligations and pay its operating expenses.

To make this insolvency legally recognized as bankruptcy, creditors seek a court order. Success in obtaining an order grants the creditors the ability to auction the company assets to retrieve their owed debt.

With this, the company completely goes out of business and maybe without any assets at the end of the day.

2. Reduced Creditworthiness

Before lending out money to companies, financial institutions measure the borrowing company's level of financial leverage.

Financial leverage is measured through different formulas that take the total debt of a company into high consideration. Companies with a high debt-to-equity ratio (a form of measurement), are regarded to be risky ventures for lending institutions. Due to this, lenders are less likely to offer financial leverage to the company.

Where lenders agree to offer leverage to this type of company, it is usually accompanied by higher interest rates. Higher interest rates are used by lenders to compensate for the risks they face.

3. Harmful Volatility of Stock Prices

In the case of a profit with financial leverage, a company's revenues increase disproportionately. This increases stock prices and, eventually, increases the dividends paid to shareholders.

Now, the problem occurs when there is a loss after a profit and stock prices need to be altered. There could be a lapse in altering the stock options or improper accounting. Increased financial leverage causes the company’s stock price to become more volatile.

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