It is measured using leverage ratios, which determine a company’s financial health and strength. Financial leverage is the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing. Financial leverage plays a significant role in influencing stock prices. Essentially, it increases the potential for higher returns for shareholders but also the risk of higher loss. In addition to these risks, it’s imperative to note that there are limitations to using the leverage ratio as the sole measure of risk. The leverage ratio does not take into account the variability of earnings, market conditions, or the nature of a firm’s assets and liabilities.

The debt-to-EBITDA ratio indicates how much income is available to pay down debt before these operating expenses are deducted from income. Keep in mind that when you calculate the ratio, you’re using all debt, including short- and long-term debt vehicles. Operating leverage is used to set the break-even point for the company, i.e., the point at which the goods should be sold to cover all the costs and earn profits.

Evaluating Financial Risk through Debt Ratio

As the use of financial leverage amplifies your possible profits, it also magnifies your possible losses. The probability of financial distress also increases even with moderate leverage if a firm has highly volatile earnings. Leverage is the use of debt to finance an organization’s activities and asset purchases. When debt is the primary form of financing, a business is considered to be highly leveraged. In essence, using debt instead of equity can boost the return that investors are experiencing. Operating leverage is defined as the ratio of fixed costs to variable costs incurred by a company in a specific period.

• Total equity includes shareholders’ funds (amount invested by the shareholders of the company) and retained earnings (amount of profits owned by the firm).
• Increased stock prices will mean that the company will pay higher interest to the shareholders.
• On the other hand, low leverage can provide a company with more flexibility to fund sustainability projects and make decisions focusing on long-term profitability and value.
• Another significant advantage of financial leverage lies in tax deductions.

Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders often charge fees, premiums, and margin rates and require you to maintain a margin account with a specific balance. This means that if you lose on your trade, you’ll still be on the hook for extra charges. Trades can become exponentially more rewarding when your initial investment is multiplied by additional upfront capital. Using leverage also allows you to access more expensive investment options that you wouldn’t otherwise have access to with a small amount of upfront capital.

What Is Financial Leverage?

They can invest in companies that use leverage in the ordinary course of their business to finance or expand operations—without increasing their outlay. This ratio shows the relationship between a bank’s core capital and its total assets. A high ratio successful use of financial leverage requires a firm to indicates higher risk, and the firm should ensure that it has enough cash flows to manage interest and principal payments to prevent bankruptcy. They take advantage of leverage by using instruments like options, futures, and margin accounts.

The practical implication here is that, by using borrowed capital for funding business activities, a firm can potentially generate a higher ROE. Of course, a discussion about leverage cannot ignore mentioning about the inherent risks. The flip side is that it can magnify losses, whether those losses stem from lower than expected returns or an unforeseen downturn in the market.

How is Financial Leverage Measured?

Although financial leverage may result in enhanced earnings for a company, it may also result in disproportionate losses. Losses may occur when the interest expense payments for the asset overwhelm the borrower because the returns from the asset are not sufficient. This may occur when the asset declines in value or interest rates rise to unmanageable levels.

Financial ratios hold the most value when compared over time or against competitors. Be mindful when analyzing leverage ratios of dissimilar companies, as different industries may warrant different financing compositions. This ratio measures the total amount of debt against a firm’s total capitalization as a percentage.