Financial Leverage Ratio Calculator
We have prepared this financial leverage ratio calculator for you to quickly estimate the financial leverage ratio. It tells you how much of the company's assets are financed using debt instead of equity. This ratio indicates the amount of leverage risk contained within an entity.
The following article will help you understand what financial leverage is and how to calculate it using the financial leverage formula. We will also demonstrate some practical examples to better help you to understand the concept.
What is the financial leverage ratio? Financial leverage meaning
Financial leverage is one most commonly used leverage ratios in the financial industry. It tells you the proportion of a company's assets being financed through liabilities instead of equity. It also measures the riskiness of a company.
More specifically, calculating the financial leverage allows you to understand how likely or capable the company is in paying back its obligations. The higher the financial leverage, the more obligations it has to pay back. Hence, the risk of the company not meeting its obligation is also higher. For example, a company might be comfortable in a high financial leverage situation when it is very profitable. Still, it can be disastrous if the performance of the company starts to decline in the future.
Now that you understand the financial leverage definition, let's see how we can calculate the financial leverage ratio.
How to calculate financial leverage? Financial leverage formula
After understanding the financial leverage definition, let's look at its calculation. Let's take Company Alpha with the below information as an example:
- Name: Company Alpha
- Current assets: $500,000
- Non-current assets: $3,000,000
- Total equity: $1,500,000
financial leverage requires 3 steps:
- Calculate total assets
The first step is to calculate the
total assetsusing the formula below:
total assets = current assets + non-current assets
In this example, the Company's Alpha's
$500,000 + $3,000,000 = $3,500,000.
- Determine total equity
You can find the
total equityfrom most companies' balance sheets. For Company Alpha, its
- Calculate financial leverage
The final step is to calculate the
financial leverageitself. We can do this using the financial leverage ratio formula below:
financial leverage = total assets / total equity
$3,500,000 / $1,500,000 = 2.33x.
Of course, our financial leverage ratio calculator is a much easier way to obtain the same results in no time.
How to interpret financial leverage?
In general, the higher the financial leverage, the more risky the company is. This is because high financial leverage increases the risk of a company defaulting.
Having high financial leverage can have its benefits. The most notable benefit is being able to amplify the return of investment (ROI) of a business or project. However, having high financial leverage will also lower the credit rating of the company due to its high-risk profile. This will increase the company's cost of equity and cost of debt, making it more expensive to acquire funding.
Lastly, it is essential to note that financial leverage is only valid when compared against its peers within the same industry. This is mainly because different industries often exhibit different dynamics. Keep it in mind while using the financial leverage ratio calculator.
What is a good financial leverage?
Different industries require different financial leverage, so it is impossible to tell if a financial leverage figure is good or bad without comparing it with its peers.
For example, the telecommunication industries tend to have high financial leverage, while the insurance industry is prohibited from doing so.
Can financial leverage be negative?
Since the financial leverage ratio formula is equal to total assets divided by total liabilities, financial leverage can never be negative. This is because a company's total assets can't be negative, as this would mean that the company is bankrupt.
What is total equity?
Total equity is defined as the difference between total assets and total liabilities. It is the value that the shareholders will claim back if the company repays all of its liabilities with all of its assets.
What is the difference between current asset and non-current asset?
Current assets are assets expected to be used in business operations in less than a year, whereas non-current assets are assets that are a company's long-term investments for which value is expected to be realized in more than a year.