There once was a young man who wanted to become a millionaire. He didn’t have much money, so he decided to borrow as much as he could from friends and family. He put the money into stocks and bonds and made some good investments. Within a few years, his investment portfolio had grown to over a million dollars.
But then the stock market crashed, and his investments lost almost all their value. He was now in debt up to his eyeballs. He had no choice but to declare bankruptcy and start over from scratch.
This is a cautionary tale about the dangers of leverage. When used wisely, leverage can be a powerful tool for building wealth. But when used recklessly – or if the market changes quickly – it can lead to financial ruin.
The notion of using borrowed money-mainly from fixed-income instruments like debt and preferred equity or preferred shares of companies-to boost a company’s return on investment (ROI) has several definitions in financial terminology.
Leverage is a well-known financial and economic approach that allows a company to increase its financial assets by leveraging its debt. The leverage of various debt instruments to enhance a company’s return on investment is the most common definition of financial leverage.
Using financial leverage does not guarantee a favorable result. The more debt a firm employs as leverage, the greater – and riskier – its financial leverage situation is in general.
Companies and their stockholders face a greater financial risk when they take on more leveraged debt, which increases the interest rate burden.
Calculation of Financial Leverage
Financial leverage may be calculated using the following formula:
Leverage = Total Debt / Total Equity
Total corporate debt and equity of shareholders is the definition of leverage.
Calculate financial leverage by following these steps:
Determine the total amount of a company’s debt, including both short-term and long-term obligations. Financial indebtedness includes both current and future obligations.
Total shareholder equity (i.e., multiplying the number of outstanding firm shares by the stock price) should be tallied.
Total debt to equity is equal to total debt divided by total shareholder equity.
And this is how a company’s financial leverage ratio may be calculated using this formula.
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If a firm has a high leverage ratio — say, three to one or greater — it puts its share price at risk and makes it more difficult to get future funding if the company defaults on its current or previous loan commitments.
Take a look at these two situations to get a better understanding of financial leverage.
A company spends $5 million to acquire a desirable piece of real estate to develop a new manufacturing facility. Five million dollars is the price of the land. This is not a case of financial leverage because the corporation is not utilizing borrowed funds to acquire the land.
Using financial leverage means paying for the same piece of property using a combination of the company’s own funds and borrowed funds totaling $2.5 million.
When a company takes out a $5 million loan to buy a property, it is said to be heavily leveraged.
Anyone who purchases property is familiar with the financial leverage indicators.