Financial Leverage Formula

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What is Financial Leverage Formula?

What is Financial Leverage Formula?

Financial leverage Equation shows business dependency on debt which means financial leverage tells how much company is dependent on borrowing and how the company is generating revenue out of its debt or borrowing. Debt can be borrowing fund from Bank 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 investments. Financial leverage equation is a total debt upon shareholder equity.

The equation of financial leverage can be written as follows:-

Here,

Total Debt = Short Term Debt + Long Term Debt

Examples of Financial Leverage Formula

Let’s see some simple to advanced examples of financial leverage equation to understand it better.

Financial Leverage Formula – 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. Calculation of Financial leverage will be.

The result will be:

So from the above calculation, the financial leverage value will be: 2.5

Financial Leverage Formula – 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 equation 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 highlight of financial leverage equation.

If a value of financial leverage is higher the more is the usage of debt which also leads to increase in expense of company in terms of processing fees and interest paid on it which may affect EPS 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 risk is also increasing as risk on market is high and the market is too volatile.
Financial risk also helps to find an actual financial position of company and risk associated company and its business.
Financial leverage equation helps the investor to know creditability of company and risk involved in term of a monetary transaction. And helps to know the return on investment and helps to calculate potential returns.

Financial Leverage Formula – 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 help of above-given Balance sheet, we have gathered 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.

What is a Degree of Financial Leverage (DFL) Formula?

There is another type of financial leverage which is very useful and that is Degree of Financial Leverage. Now, let us discuss it in brief.

The Degree of Financial Leverage formula is the ratio of percentage of change in EPS to the percentage of change in EBIT. This change happens due to a change in the capital structure of a company. DHL is very important for a company as it helps to know the quality of debt and also impact the capital structure of a company. Here, EPS is earning per share and EBIT is earnings before interest and tax.

The formula for Degree of Financial Leverage is as follows:-

Example of Degree of Financial Leverage Formula (DFL)

Suppose a company Jin Décor has EPS 14.25 in 2017 and EPS change to 17.40 in 2018, EBIT value in 2017 was $100,120 and in 2018 value is 185,689. Now, let us now do the calculation using Degree of Financial Leverage formula which is.

Solution:

First, we have calculated the % of the change in EPS and % of the change in EBIT using the following formula.

Percentage of Change of EPS:

Percentage of Change of EBIT:

So in the below-given template is the calculation using Degree of Financial Leverage formula

So, the Degree of Financial Leverage formula calculation will be –

So, DFL for Jin Decor will be 0.259.