This financial leverage ratio calculator finds the proportion of the total debt a company has against its shareholder’s equity, showing the extent to which a company is using external sources to finance its activity. There is more information about the formula used below the tool.
How does this financial leverage ratio calculator work?
The formula used by this financial leverage ratio calculator considers the figure of the shareholder’s equity and the one of the total debts.
Often referred to as the trading on equity or simply leverage it indicates the amount of debt a business or investor uses to buy or finance assets, while it has several formulas (FL) in the specialty literature:
FL = Total Debts / Total Assets
FL = Total Debts / Total shareholder’s equity
FL = Total Debts / Total owner’s equity
FL = Total Debts / Total stockholder’s equity
The interpretation of the financial leverage level
There are no predefined levels that could help in understanding which is an optimal value for the investment leverage indicator since its levels vary from one industry to another, from one market to another or from one economical context to another. For instance there are cases in which companies, investors and business owners are advised by the financial experts to borrow money and develop their business. This is usually advisable in case the money taken and then invested can generate a return that exceeds the expenses with the interest paid associated with the debt.
However, generally speaking in case the operational leverage ratio of an entity is higher than 2 (200%) it can be interpreted as a signal of financial weakness for the business in question; while in case it is even higher than that it may be seen as an even riskier position because it may result in bankruptcy in case the interest rates go up and the entity proves incapable of paying its debts in due time.
Basically there are 2 advantages an increased level of the financial leverage ratio can offer:
First is that in certain jurisdictions there are some favorable tax treatments meaning that the interest expenses are deductible and so companies are incentivized to use external sources to finance their activity and assets.
Second is that by borrowing more money in case the interest expenses are lower than the total return generated by the debt, corporations or investors can earn more by borrowing.
Example of a financial leverage ratio calculation
Let’s assume that a retailer has:
Total debts of $100,000
Total shareholder’s equity = $90,000
In this scenario the financial leverage is 1.11 (or 111.11%).28 Apr, 2015 | 0 comments