What is financial leverage?
Financial leverage is a story of assets and their returns on one side, and the way the
assets are financed on the other side.
The concept of financial leverage can be applied to companies, investment portfolios, and even
to the house you own.
In this example, we look at a factory with $1 million in assets (buildings, machines,
inventory, etcetera).
These assets generate an annual net income of $100,000.
The return on assets is therefore 10%, $100K in net income divided by $1 million in assets.
How are these assets financed?
Let’s assume the assets are financed fully by equity, shareholder capital.
$100K net income divided by $1 million in equity is 10% return on equity.
So far, so good.
Equity is not the only way to finance assets.
You could also go to the bank for a loan.
How about financing the assets 50% with equity, and 50% with debt.
Debt hardly ever comes for free, let’s assume the net income drops to $80,000 due to the
interest charged.
Return on assets is now 8%: $80,000 net income divided by $1 million in assets, which is
lower than the 10% we had before.
Return on equity goes up: $80,000 in net income divided by $500,000 in equity is 16%.
This is the effect of financial leverage!
Return on equity was 10% when the assets were financed fully by equity, and return on equity
is 16% when the assets are financed 50/50 with equity and debt.
How about taking that one step further.
What if we finance the assets with $200,000 in equity and $800,000 in debt?
Net income drops to $68,000, and return on assets drops accordingly to 6.8%.
Return on equity however goes up dramatically.
$68,000 in net income divided by $200,000 in equity
generates a return on equity of 34%!
One more step.
What if we finance the assets with only $100,000 in equity and a massive $900,000 in debt (assuming
you can find a bank that is willing to grant or arrange a loan
with that kind of financial leverage)?
Net income drops to $64,000, and return on assets drops accordingly to 6.4%.
Return on equity goes up dramatically.
$64,000 in net income divided by $100,000 in equity
generates a return on equity of 64%!
Let’s summarize these four financial leverage scenarios, with the very important disclaimer
that we are assuming a very linear and very stable world.
In this specific example, $1 million in assets fully financed with equity generate 10% return
on assets and 10% return on equity.
The same assets financed 50/50 between equity and debt, generate 8% return on assets and
16% return on equity.
The financial leverage is 2: for every dollar of equity, there are two dollars of assets.
If financial leverage is 2, then ROE is 2 times ROA.
When we go to 20% equity and 80% debt, ROA drops to 6.8% while ROE jumps to 34%.
The financial leverage is 5: for every dollar of equity, there are five dollars of assets.
If financial leverage is 5, then ROE is 5 times ROA.
It looks like the higher the financial leverage, the higher the return on equity.
When we go to 10% equity and 90% debt, ROA drops to 6.4% and ROE could skyrocket to 64%.
The financial leverage is 10: for every dollar of equity, there are ten dollars of assets.
If financial leverage is 10, then ROE is 10 times ROA.
Why do we mention the word “could” in one of the previous sentences?
Well, real life can be far more volatile than a nice clean example on paper.
What if the $64,000 net income turns into an unexpected loss of $200,000?
In a high financial leverage situation, this completely wipes out the existing equity.
Either the shareholder urgently contributes more equity to the company, or the bank will
take possession of the assets, which were the collateral for the loan.
Financial leverage can “multiply” gains….
and wipe out equity in case of unexpected losses.
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