Definition of Financial Leverage
Financial leverage is the degree to which an entity uses interest-bearing debt to finance its assets.
The higher the share of debt financing in the capital structure of the company, the higher the financial leverage and also the financial risk.
A high proportion of financial debt also means high-interest payments. Which may have a negative impact on the company’s earnings per share. And in the worst case, even lead to insolvency.
Financial Leverage Example
Imagine you are an investor.
You buy a condominium for USD 200,000 and pay fully in cash. At present, virtually you have no financial risk.
In another scenario, you buy a multi-family house for USD 800,000. Out of which you pay USD 200,000 in cash and borrowed USD 600,000 from the bank.
Now, let us see what happens when financial leverage comes into effect.
First, think about positive leverage.
If the market price of real estate increases by 25%,
Then in first case, the value of the condominium will increase from 200,000 to 250,000. You will have a return of 25% on your equity.
In second case, the value of the multi-family house increases from 800,000 to 1,000,000 and you will have a return of 100% on your equity. The amount you invested from your own, equity share increases from 200,000 to 400,000.
When real estate prices fall by 25%,
Then in case of the multi-family house, the equity would be completely used up. Because the value of multi-family house becomes 600,000, and your mortgage is also 600,000.
While for the fully self-financed condominium, it would only decrease by USD 50,000.
Financial leverage is a double-edged sword.
That is why financial leverage therefore only be used up to the extent at which the financial risk remains manageable. It strongly depends on the type of company, ie the business model, the fixed cost intensity, etc.
Financial Leverage Formula:
The formula used to calculate the company’s financial leverage puts the percentage change in net income or pre-tax profit EBT in relation to the percentage change in EBIT.
Therefore, Financial leverage is a measure of the sensitivity of net income to changes in EBIT as a result of changes in interest payments or debt.
Financial Leverage Interpretation:
Under same tax rate and without use of borrowed funds, the financial leverage of a company is equal to 1.
If the EBT increases more than the EBIT, then the effect of the financial leverage is positive (> 0).
On the other hand, if EBT increases less strongly than the EBIT, then the change in debt has a negative effect (<0).
Of course, other factors such as interest income, refinancing at changed interest rates, etc., may also play a role.