Formula to Calculate Financial Leverage
Financial leverage tells us how much the company is dependent on borrowing and how the company is generating revenue out of its debt or borrowing, and the formula to calculate this is a simple ratio of Total Debt to Shareholders Equity.
Here,
Total Debt = Short Term Debt + Long Term Debt.
Debt can be borrowing funds from banks in the form of a loan or by issuing equity in a market to get the funds. These funds help a company to grow, generate revenue, increase its share price and market standard, which leads to increase fund performance and potential to give a high rate of return on investmentsRate Of Return On InvestmentsRate of Return on Investment is the rate at which a company generates a return on investment during a period when compared to the cost of the investment made by the company. It is calculated by dividing the return on investment during the period by the cost of the investment.read more.
Financial Leverage Calculation Examples
Let’s see some simple to advanced examples to understand it better.
Example #1
Let’s see an example to understand the calculation of financial leverage formula.
Suppose a company Star Logistic Pvt. Ltd wants to know its financial leverage; the company had a debt of $100,000 and shareholder’s equity of $40,000. The calculation of Financial leverage will be.
- The result will be:
So from the above calculation, the financial leverage value will be: 2.5
Example #2
A company named Apple Pvt. Ltd purchased machinery at $100,000 in cash, and by using that company has generated revenue of $150,000. Whereas other company named Kiwi Pvt. Ltd has taken a loan to buy the same type of machinery, and it also wants to generate revenue of $150,000. Kiwi uses financial leverage to generate revenue, but unfortunately, Kiwi has faced a loss of $300,000.
Financial leverage helps a company to enhance earning and for tax treatment to reduce the net cost of borrowing as interest expense is tax-deductible. There are below a highlight of financial leverage.
- If the value of financial leverage is higher, the more is the usage of debt, which also leads to an increase in the expense of the company in terms of processing fees and interest paid on it, which may affect the EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more and profitability of a company.
- Whereas if the value of financial leverage is low, that means a company is issuing a lot of equity and financial securities to raise the fund 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 riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more also helps to find an actual financial position of the company and risk associated company and its business.
- Financial leverage helps the investor to know the creditability of the company and the risk involved in terms of a monetary transaction. And helps to know the return on investment and helps to calculate potential returns.
Example #3
Let’s see an example of the calculation of financial leverage. Suppose below is the Balance sheet of a company Rolta Pvt. Ltd for the year 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
Now, let us now do the calculation of financial leverage for all the years using the above information.
So the financial leverage calculation for the year 2016
Financial Leverage calculation for the Year 2017
Financial Leverage calculation for the Year 2018
So, financial leverage increases from 28% in 2016 to and from 33% in 2017 to 34% in 2018.
Financial Leverage Calculator
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Relevance and Uses
Uses of the Financial Leverage equation are as follows:-
- Financial leverage is used 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 financial risk pertaining to the company.
- Financial Leverage also helps in making major decisions for a company.
The financial leverage equation is a very important and sensitive thing as borrowing fund helps a company to grow and increase profit, but there is also rick involve, which can lean to company potential loss. There are mainly two factors needed before considering the value of leverage, and that factors are Economical condition of industry and type of industry.
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This has been a guide to Financial Leverage Formula. Here we discuss how to calculate financial leverage and also the degree of financial leverage formula along with practical examples. You can learn more about Financial Analysis from the following articles –
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