Financial Leverage Explained: Types, Formulas & Examples

Financial leverage is a term often used in the world of finance and investing, referring to the use of loans to attain potential returns on an investment. With this approach, business owners get the chance to attain funds or capital instantly for their business and increase the profits they can generate from their operations or investments.

Table of Content

• What is Financial Leverage?
• Types of Financial Leverage
• Key Formulas for Financial Leverage
• Examples of Financial Leverage

What is Financial Leverage?

Often, businesses need instant funds to buy assets, invest in projects or expand their operations. While equity is a method to increase capital, borrowing funds from a lender is also a great option. This specific approach is known as financial leverage, where businesses borrow money to invest in something, with the goal of increasing potential returns or growing their business.

Investors use leverage to amplify profits, often through options, futures, or borrowed funds. Companies use leverage by borrowing money to run operations or buy assets instead of raising funds by selling stock. Even investors who don’t take a personal loan or borrow directly can still benefit from leverage by investing in companies that use debt effectively to expand their business.

Types of Financial Leverage

There are several types of financial leverage that are commonly used, each with varying levels of complexity and risk. These include:

Operating Leverage

Operating leverage refers to how much a business depends on fixed or variable costs to produce goods or services. Fixed costs remain the same regardless of output and must be paid even if the business loses money. A company has high operating leverage when fixed costs are higher than variable costs. It can increase profits, but it also increases financial risk.

Combined Leverage

It is the combined approach of both operating leverage and financial leverage. It is a more comprehensive measure of how changes in sales or revenue affect the profitability of a business. Companies with high combined leverage experience major fluctuations in profits due to both fixed operational costs and financial debt obligations.

Financial Leverage

The meaning of financial leverage is the total funds a business borrows to buy assets or fund projects. By using debt, a company or investor can increase the amount of capital available to improve returns, without diluting equity ownership. Financial leverage can increase the return as well as the risk of an investment, as the cost of debt (interest payments) must be paid regardless of the investment’s performance.

Suggested Read: Understanding Financial Security: Meaning, Importance & Benefits

Key Formulas for Financial Leverage

To better understand the financial leverage formula, it is helpful to know the key methods used to measure its effect on a company’s financial health.

Debt to Capital Ratio

This ratio compares the debt of a company to its total capital, or debt plus equity. The formula is Total Debt / (Total Debt + Total Equity). The Debt to Capital Ratio includes both short- and long-term debt.

Debt to Equity Ratio

Debt to Equity ratio measures the fraction of debt compared to shareholders’ equity. This financial leverage ratio formula is Debt to Equity (D/E) = Total Debt / Total Equity. A ratio above 1 indicates the company uses more debt than equity.

Interest Coverage Ratio

This ratio assesses how effectively a company can manage to pay its interest payments. While most prefer to keep this ratio over 3, a good interest coverage proportion varies from industry to industry. It is calculated as Operating Income/Interest Expense. 

Suggested Read: What is the Interest Coverage Ratio and Why is it Important?

Total Debt to Total Assets Ratio

This ratio shows the portion of a company’s assets financed through debt. It is calculated with the formula, Total Debt to Total Asset Ratio = Total Debt / Total Assets.

Debt to EBITDA Ratio

Debt to EBITDA or Earnings Before Income Tax, Depreciation, and Amortisation - this ratio compares a company’s debt to its earnings before interest, taxes, depreciation, and amortisation. It is calculated as Debt/EBITDA. A higher ratio reflects greater financial leverage.

Equity Multiplier

This ratio measures how much of a company’s assets are financed by equity. It is calculated as Total Assets/Total Equity. In case the equity multiplier is low, it shows that the company’s assets are largely financed with equity.

Examples of Financial Leverage

Let’s say a company, ABC, wants to buy a machine worth Rs. 5,00,000 and has two financing options: equity or a mix of equity and debt.

Equity Financing

If ABC chooses equity, they’ll give up part of the company but fully own the machine from the start. If the machine’s value rises by 30%, it’s worth Rs. 6,50,000, giving them Rs. 1,50,000 profits. If it falls by 30%, it’s worth Rs. 3,50,000, resulting in a Rs. 1,50,000 loss.

50/50 Equity and Debt

If ABC uses a combination of stock and debt, and the machine’s value rises by 30%, it’s worth Rs. 6,50,000. The company can use the profit to pay off the debt faster and eventually own the machine outright.

While financial leverage can enhance profitability, it is essential to maintain a balance and manage the associated risks effectively.

Muthoot Finance, the most trusted financial services company, helps businesses and individuals attain financial leverage by offering a range of loan solutions, such as personal loans, business loans, gold loans, etc. Visit your nearest Muthoot Finance branch to know more.