Leverage ratio: How does it affect companies?

The financial leverage ratio is an improved debt ratio, in which the solvency of the company is analyzed from an economic and financial point of view.

What is the Financial Leverage Ratio?

The financial leverage ratio studies the relationship between debt and equity, on the one hand, and the effect of financial expenses on ordinary results, on the other.

Financial leverage involves the inclusion in a company's capital structure of debt that pays a fixed return. It is well known that no creditor would be willing to lend funds without the cushion and security provided by equity capital, i.e. the use of the existence of a given amount of equity capital as a basis for borrowing.

How to calculate it? Financial Leverage Ratio Formula.

In principle, financial leverage is positive when the use of debt makes it possible to increase the financial profitability of the company, and in this case, debt is desirable to increase this financial profitability. How can financial profitability be increased? Shareholders' equity must decrease more proportionally than net profit.

The formula for calculating the leverage ratio is as follows:

We can differentiate the values of the result of the leverage ratio calculation according to whether they are greater than, equal to or less than 1: 

Financial Leverage Greater than 1

The return obtained by investing the interest-bearing borrowed funds received is higher than their cost, which leads to an increase in the return on equity. In this case, it is important to increase borrowed funds, until they are close to 1, since the return on borrowed funds is higher than their cost.

Financial Leverage Equal to 1

The return obtained from investing the interest-bearing borrowed funds received is equal to their cost, so that the return on equity remains unchanged. Ideally, the financial leverage should be close to 1, because in this case it is indifferent to use one type of financing or the other.

Financial Leverage Less than 1

The return obtained from investing the interest-bearing borrowed funds received is lower than their cost, thus reducing the return on equity. This financial leverage of less than 1 means a negative difference between the yield and the cost of the borrowed funds, and results in a decrease in the return on equity. In this case, the ideal is to renegotiate the cost of debt or reduce it by replacing it with equity.

Interpretation of the Financial Leverage Ratio.

A high value of the financial leverage ratio would mean a higher degree of indebtedness with a negative financial impact, worsening the solvency of the company. However, this situation can be beneficial from an economic point of view, for the following reasons:

• It serves as a barrier to inflation.
• It is a cheaper source than equity for two reasons:

1. - the interest cost of the debt is fixed, so that whenever it is lower than the yield obtained on the funds, this excess yield accrues to the benefit of shareholders' equity.
2. - Unlike dividends, which are considered a distribution of profits, interest on debt is considered an expense and is therefore deductible.

Related content

• Financial ratios. What they are and what types exist
• Economic and financial management of a company
• Cost structure of a company: What is it and how to create it?

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Advantages of financial leverage

Other advantages of financial leverage can be summarized as follows:

• Fast-growing companies can avoid profit dilution by issuing debt.
• If interest rates rise and all other circumstances remain constant, a leveraged company paying fixed interest rates will be more profitable than its unleveraged competitor. But if interest rates rise and other variables, such as the inflationary component, change, the leveraged company may suffer a setback in profitability.

Why is it important to take into account the leverage ratio in companies?

The financial leverage ratio is a measure of the analysis of the opportunity cost in companies, since it is necessary to fully analyze whether the company is going to take on debt from third parties or finance itself through its own funds. 

This ratio makes it possible to take into account both the company' s balance sheet and its income statement, considering both financial and economic factors. It represents a more exhaustive measurement of indebtedness than the classic solvency and debt analysis of companies.

In the case of third party risk management, especially in operations with large suppliers, it is essential to perform this analysis for efficient decision making. 

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