Financial leverage: what it is and how to calculate it
Debt isn't always a bad thing. In fact, investors and entrepreneurs can use it as a strategic tool to boost their profits. Here, learn what financial leverage is and how to calculate it.
5 min read
News flash: Debt isn’t always a bad thing. In fact, some investors use debt to their strategic advantage. The concept is called financial leverage, and it’s a technique that companies and investors use to increase their profits — but it's not without risks. Here, we’ll explain what financial leverage is and how to calculate it, so you can make informed financial decisions on your investment journey.
What is financial leverage?
Financial leverage means borrowing extra capital and investing it in the hopes of increasing the potential returns. Essentially, investors or businesses can take on debt and use it to fund additional investments. If the return on investment (ROI) is higher than the cost of borrowing the money, the investor can profit from the difference. These kinds of investments are also called “leveraged positions” in the market.Although financial leverage can sound pretty appealing, it also comes with significant risks that any investor should consider carefully first. Here are some of the pros and cons:
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Leverage can boost returns if investments perform well, allowing businesses or investors with less capital to earn higher profits.
Financial leverage lets investors or companies pursue more opportunities to grow.
In many cases, interest payments on debt can be tax-deductible, which reduces the overall cost of borrowing.
Risks of financial leverage
If the investment or project underperforms, you still need to pay off the debt. This can lead to significant losses.
High levels of debt can limit cash flow and put investors at higher risk of insolvency, especially if market conditions aren’t good.
Leveraged positions can be more vulnerable to market fluctuations. This increases risk, especially if the economy is volatile.
Whether you’re an entrepreneur or growing your investment portfolio, it’s important to understand the benefits and risks so you can manage leverage effectively.
Types of leverage
Leverage takes different forms within a business or an investment, and each form has its own purpose in boosting returns and growth. Let's look at the two types below:
Operating leverage
Operating leverage refers to how a company uses fixed costs in its operations. It measures the impact of changes in sales volume on a company's earnings before interest and taxes (EBIT). Businesses with high operating leverage have a larger proportion of fixed costs (like rent, equipment, or salaries) and relatively lower variable costs (like raw materials). This means that small changes in revenue can lead to a larger change in profitability, as fixed costs remain constant.
Financial leverage
Financial leverage involves using debt to purchase assets or to fund growth. The more debt a company takes on, the higher its financial leverage. The goal is for the return on the borrowed funds to be more than it cost to borrow them — if that happens, investors can reap the benefits.
How to calculate financial leverage
As a calculation, financial leverage measures the ratio of debt to equity. In simple terms, it shows what the balance of debt and equity looks like within a company or an investment. This number helps investors and entrepreneurs assess the risk and potential return associated with borrowing money, and it’s most often used in companies rather than by individual investors. The most common formula for calculating financial leverage is:Financial leverage = Total equity/Total debtThis formula shows the ratio of debt to equity in a company’s capital structure. A higher leverage ratio indicates that a company uses more debt than its equity, which can amplify returns but increase risk.
Calculating financial leverage for a business
Let’s say a company has the following financials:
Total debt: €500,000
Total equity: €250,000
Then, let’s use the equation to calculate the financial leverage:Financial leverage = 250,000/500,000This means the company has a leverage ratio of 0.5, or 50%, indicating that it uses 50 cents of debt for every euro of equity. Generally, 0.5 is considered a low level of leverage. Financial leverage ratios can be classified as:
Low financial leverage (below 1): A company with low leverage uses more equity than debt to finance its operations, which typically translates to lower risk.
Moderate financial leverage (around 1): This shows a balanced use of debt and equity, giving the company the flexibility to manage its obligations while pursuing growth.
High financial leverage (above 1): This suggests the company is highly leveraged and using more debt than equity. This can help with growth, but it increases the risk of financial trouble if the company's cash flow can't cover their debt repayments.
Why is financial leverage important for investors?
Just like for companies, financial leverage can be a powerful tool for investors. It can give investors the flexibility to spread more capital across various asset classes and strategies. There are also different forms of leverage — such as margin loans in stock trading or mortgages in real estate investing — depending on market conditions and your personal financial goals.Even though financial leverage can enhance returns, increase buying power, and provide growth opportunities, it’s not necessarily the right tactic for everyone. Before you dive in, make sure you understand how leverage fits into your overall strategy, and think about your risk tolerance, goals, and market conditions.
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FAQs
Operating leverage relates to the company's internal cost structure. Financial leverage focuses on the company’s capital structure and debt levels.
Small businesses can use financial leverage by borrowing to invest in growth opportunities, like expanding their operations or purchasing equipment. But for this to work, the business needs to have stable cash flow to meet its debt obligations. It's also wise to avoid over-leveraging, which can be financially risky. Instead, most experts recommend maintaining a balanced debt-to-equity ratio and focusing on investments that drive revenue.
Before using financial leverage, investors should think carefully about their risk tolerance. It’s important to assess the stability and potential returns of the investment to ensure it can cover the borrowing costs. Investors should also look at the terms of the loan or debt, including interest rates and repayment schedules. And always make sure you have enough money or liquidity to repay the debt, even if the market goes down.
Financial leverage is a significant business tactic and can definitely impact a company's stock price. If debt-financed investments perform well and earn more than the cost of borrowing that money, that means higher company profits. In turn, this leads to higher earnings per share (EPS) and more investor confidence, driving up stock prices. However, if a company can't pay its debts or if investments don't do well, it can cause financial problems. This can then affect investor sentiment and push stock prices down.
Yes, many countries regulate financial leverage in companies, with the goal of protecting investors and ensuring economic stability. They may create guidelines on acceptable debt-to-equity ratios, set capital adequacy requirements for financial institutions, and require companies to disclose debt levels and associated risks in their financial statements. Regulatory bodies, such as the BaFin in Germany, also monitor companies to make sure they’re in compliance with regulations.
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