Financial leverage is financial term which represents a technique by which a person or a company multiplies its financial gains. The most usual way of using financial leverage is investing borrowed money, or taking credit, to buy assets, which will then in time achieve greater funds than it was borrowed. In this way it is possible to create greater profit than it was possible without the borrowed money. There is a certain amount of risk accompanying this type of investment. In case the bought investment doesn’t achieve the greater amount of financial gain than the originally borrowed finances, there will be losses.
- People usually leverage finances on their saving accounts so they can buy houses, apartments, cars, etc.
- People can leverage their savings to repay mortgage debt
- Companies can leverage part of money which is not covered by investors , so the returning profits or losses are shared on smaller ground and have higher returns
- Businesses can leverage part of their investments which is not fixed, if they want to have fixed investments on their part and leveraging the rest, if there is the need for variable investments
There is a great risk involved when dealing with financial leverage. When a company or an individual uses leverage to invest into something, there is a chance that the returning profits won’t be bigger or even equal to the amount of borrowed money. The bigger the leverage the bigger is the returning earned money, but that also goes if the investment fails – the bigger the leverage, more money is owned which can lead the company or an individual into bankruptcy.
Calculating the financial leverage
- Financial leverage is calculated by dividing total debt with shareholders equity.
- Level of operating leverage can be calculated by dividing the sum of EBIT (Earnings before interest & taxes) and Fixed costs by Earnings before interests and taxes.
- Degree of financial leverage is calculated by dividing Earnings before interest and taxes with the difference in earnings before interests and taxes and total interest expense.
- Degree of combined leverage is calculated by multiplying degree of operating leverage with degree of financial leverage, or by dividing the sum of earnings before interest and taxes and fixed costs with the difference in earnings before interest and taxes and total interest expense.
- Operating leverage is defined when the % increase / decrease of operating income is divided by difference in % in sales of a company.