financial leverage

(noun)

The degree to which an investor or business is utilizing borrowed money.

Related Terms

Examples of financial leverage in the following topics:

  • Combining Operating Leverage and Financial Leverage

    • To calculate total leverage, we multiply Degree of Operating Leverage by Degree of Financial Leverage.
    • Operating and financial leverage can be combined into an overall measure called "total leverage. " Total leverage can be used to measure the total risk of a company and can be defined as the percentage change in stockholder earnings for a given change in sales.
    • Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.
    • Fully derived, we see that to multiply Degree of Operating Leverage and Degree of Financial Leverage, we subtract fixed costs and interest expense from the total contribution margin (revenue minus variable cost times the number of units sold), and divide total contribution margin by this result.
    • TL = Total Leverage.

  • Leverage Models

    • Models that allow us to interpret appropriate financial leverage include the Modigliani-Miller theorem and the Degree of Financial Leverage.
    • There are several measures we can use to define and quantify the effect of financial leverage.
    • Financial leverage can be measured, or defined, using certain ratios.
    • The higher the Degree of Financial Leverage, the riskier the business.
    • Financial leverage is defined as the ratio of operating income to net income.

  • Impacts of Financial Leverage

    • The use of financial leverage can positively - or negatively - impact a company's return on equity as a consequence of the increased level of risk.
    • At an ideal level of financial leverage, a company's return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.
    • However, if a company is financially over-leveraged a decrease in return on equity could occur.
    • Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments.
    • There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage.

  • Defining Financial Leverage

    • Financial leverage is a tactic to multiply gains and losses, calculated by a debt-to-equity ratio.
    • The standard definition of financial leverage is as follows:
    • This results in a financial leverage calculation of 40/60, or 0.6667.
    • Before Lehman Brothers went bankrupt, they were leveraged at over 30 times ($691 billion in financial leverage compared to $22 billion in assets).
    • Calculate financial leverage, and recognize the core relationship between risk and return

  • Financial Leverage

    • Financial leverage is a technique used to multiply gains and losses by obtaining funds through debt instead of equity.
    • Financial leverage is a general term for any technique to multiply gains and losses.
    • The concept of financial leverage is much more utilized and understood in the realm of corporate finance.
    • Financial leverage tries to estimate the percentage change in net income for a one percent change in operating income.
    • This is a situation in which a company or individual enters into financial distress and is forced to enter into a higher leveraged position.

  • Financial Structures

    • Understand how to qualify and leverage financial incentives through the Small Business Administration (SBA).

  • The DuPont Equation

    • Financial Leverage = 5,000,000/10,000,000 = 50%.
    • Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage.
    • As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity.
    • Finally, some industries, such as those in the financial sector, chiefly rely on high leverage to generate an acceptable return on equity.
    • In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage.

  • Debt-to-Equity Ratio

    • The Debt-to-Equity Ratio is a financial ratio that compares the debt of a company to its equity and is closely related to leveraging.
    • The Debt-to-Equity Ratio is a financial ratio indicating the relative proportion of shareholder's equity and debt used to finance a company's assets, and is calculated as total debt / total equity.
    • For more advanced analysis, financial analysts can calculate a company's debt to equity ratio using market values if both the debt and equity are publicly traded.
    • When used to calculate a company's financial leverage , the debt-to-equity ratio includes only long-term liabilities in the numerator and can even go a step further to exclude the current portion of the long-term liabilities.
    • Graph of how infamous investment banks were leveraged prior to the credit crisis of 2008.

  • Defining Operating Leverage

    • Operating leverage is a measure of how revenue growth translates into growth in operating income.
    • Therefore, companies with low output would not benefit from increased operating leverage.
    • Therefore, operating leverage is used much more than financial leverage for these types of firms.
    • Operating leverage also increases forecasting risk.
    • Various measures can be used to interpret operating leverage.

  • Types of Private Financing Deals: Going Private and Leveraged Buyouts

    • The debt thus effectively serves as a lever to increase returns, which explains the origin of the term leveraged buyout (LBO).
    • The term LBO is usually employed when a financial sponsor acquires a company.
    • As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition.
    • LBOs have become attractive, as they usually represent a win-win situation for the financial sponsor and the banks: The financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending.
    • The amount of debt banks which are willing to provide and support an LBO varies greatly and depends on the quality of the asset to be acquired--stability of cash flows, history, growth prospects, and hard assets; the amount of equity supplied by the financial sponsor; and the history and experience of the financial sponsor.