Formula to Calculate Financial Leverage

Financial leverage tells us how much the company depends on borrowing and how it generates revenue from its debt or borrowing. Calculating this is a simple total debt to shareholders equity ratio.

Financial Leverage Formula = Total Debt / Shareholder’s Equity

Here,

Total Debt = Short Term Debt + Long Term Debt.

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 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 us see some simple to advanced 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

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 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, 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 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 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 2018Total Debt = 13,437 for 2016, 17,286 for 2017 and 21,230 for 2018Total 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.

Financial Leverage Calculator

Relevance and Uses

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.

This article is a guide to Financial Leverage Formula. Here, we discuss the calculation of financial leverage, along with practical examples. You can learn more about financial analysis from the following articles: –

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