What Is Financial Leverage?

Investors use this strategy in an effort to multiply their gains and, in turn, grow their overall asset base. Operating leverage influences operating income, whereas financial leverage assesses stockholders’ earnings per share. A company lays this out on its balance sheet and income statement. The concept helps businesses to have funds to expand their venture and put efforts into earning more than their cost of borrowing.

Investors can calculate operational leverage by dividing the company’s change in earnings per share by its percentage change in its earnings prior to interest and taxes. A higher degree of operating leverage demonstrates a higher level of volatility within the company. While a company’s “leverage” is most commonly referencing its financial leverage ratio, another form of leverage is its operating leverage. A company’s operating leverage is the relationship between a company’s fixed costs and variable costs. Leverage is a common financial concept you may often hear in reference to maximizing investor returns. Commonly used by investors and companies alike, leverage is a technique that utilizes debt instead of equity to buy an asset.

Leverage Example

Leverage is the method of using debt to finance an undertaking that will provide returns that exceed the cost of that debt. If the home’s value increases 10% to $550,000, your gains would be magnified to 50%. That’s because an increase of $50,000 is only 10% of the home’s value, but is a 50% increase on your investment of $100,000. In the spring of 2007 about the dangers of excessive financial leverage. Shadow banks’ collateralised funding is also considered a risk because it can lead to high levels of financial leverage.

Basel II attempted to limit economic leverage rather than accounting leverage. It required advanced banks to estimate the risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to estimation error, both honest and opportunitistic.

How Financial Leverage is Measured

In the case of a financial leverage flow loan, the general creditworthiness of the company is used to back the loan. Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005.

You could consider mutual funds or exchange-traded funds that apply leverage to their investment strategy. By purchasing these investment vehicles, you can indirectly delegate the research to savvy investment experts. Given the high financial leverage and the group’s having initially paid above-market prices, many of their loans were underwater. Competitive businesses require more equity and less financial leverage than monopoly businesses.

When to Use Financial Leverage

There is an implicit assumption in that account, however, which is that the underlying leveraged asset is the same as the unleveraged one. Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels. DuPont analysis uses the “equity multiplier” to measure financial leverage. One can calculate the equity multiplier by dividing a firm’s total assets by its total equity. Once figured, one multiplies the financial leverage with the total asset turnover and the profit margin to produce the return on equity. The term financial leverage is also used to describe the overall debt load of a company by comparing debt to assets or debt to equity.