What is Financial Leverage Ratio?
A financial leverage ratio is one of the important financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations.
The leverage ratio category is vital because companies believe a combination of equity and debt to finance their operations and knowing the quantity of debt held by an organization is helpful in evaluating whether it pays its debts off as they are available due.
In other words, the financial leverage ratios measure the general debt load of an organization and compare it with the assets or equity.
This shows what the quantity of the firm assets belongs to the shareholders instead of creditors. When shareholders own a majority of the assets, the firm is claimed to be less leveraged.
When creditors own a majority of the assets, the firm is taken into account highly leveraged.
All of those measurements are important for investors to know how risky the capital structure of an organization and if it’s worth investing in.
Advantage of Financial Leverage Ratio
- This ratio focus on the long-term solvency of the company with regards to how much capital comes in the form.
- This ratio measures the long-term stability and structure of the firm.
- This ratio also helps in determining the quantum of debt that can be borrowed.
- This ratio helps in determining the effect of debt on the overall profitability of the company.
Disadvantage of Financial Leverage Ratio
- A large value for leverage means a much higher interest rate, resulting in higher interest expenses.
- this can negatively affect the firm’s bottom line and earnings per share.
- There are several kinds of risks associated with the finances of a business
Debt-to-Equity Ratio= Equity Total Liabilities (Debts) / Total Shareholders’
You can learn:
Ratiosys’s has $14.50 billion in debt and $4.14 billion in equity, as of fiscal year ended 2020. The company’s debt-to-equity ratio is thus:
= $14.50 billion÷$4.14 billion=3.50 Ratiosys’s liabilities are 350% of shareholders’ equity which is very high for a retail company.
A high debt to equity ratio usually shows that a firm has been forceful in financing its growth with debt. This may outcome in impulsive income as an effect of the added interest expense.
If the firm’s interest expense grows too more, it may increase the firm’s probability of a default or bankruptcy.
Typically, a D/E ratio greater than 2.0 indicates a risky scenario for an investor; however, this yardstick can vary by industry.
Businesses that require large capital expenditures, such as utility and manufacturing companies, may need to secure more loans than other companies.
It’s an excellent initiative to determine a firm’s leverage ratios in opposition to past performance and with companies operating in the same industry to better understand the information.
Analysis and Interpretation of Financial Leverage Ratio
This ratio helps the company to determine how much amount they can borrow so as to increase the profitability of the company.
This ratio also helps in determining the quantum of debt that can be borrowed.
This ratio helps to determine the effect of debt on the overall profitability of the company – a high ratio means the fixed cost of running the business is high, whereas, this ratio indicates lower fixed cost investment in the business.
The higher the value of leverage, the more that particular firm uses its issued debt. A large value for leverage means a much higher interest rate, resulting in higher interest expenses.
And this can negatively affect the firm’s bottom line and earnings per share.
But at the same time, the leverage value should not go down too low, as the firms issuing too much equity is considered less secure because the amount of risk in equity markets is too high.
So in a way, leverage is also an effective way to understand and analyze financial risks faced by an organization in its business.
Financial risk is a single word used as a general term for several kinds of risks associated with the finances of a business.
These risks include all the risks involving monetary transactions, such as the company’s loans, and its exposure to loan default.
The term is often used to reflect an investor’s uncertainty regarding the collection of returns and also the potential of a financial loss.
It refers to the use of different financial instruments or borrowed capital in order to increase the firm’s potential ROI or return on investment.
When given a generalized and more technical definition, the financial leverage ratio is the extent up to which a firm utilizes the available financial securities, such as equity and debt.
It indicates the extent of reliance on a firm’s business over the available debt in the firm’s business operations.