Degree of financial leverage is an indicator measuring the change in the return on equity, achieved with the involvement of loans. In other words, financial leverage can be referred as the degree to which net operating assets are financed by borrowing with net financial obligations or by equity. It can be computed as follows:
DFL = (1 – t) × (ROA – r) × (D ÷ E)
In this formula, DFL – degree of financial leverage, in percent; t – profit tax rate, on a relative basis; ROA – return on assets, in percent; r – debt capital interest rate; D – debt capital; E – equity.
Positive impact of the financial leverage effect is based on the statement that in normal economic environment bank rate is lower than the return on investment. Negative impact (also referred as the reverse effect of financial leverage) makes itself evident when the return on assets becomes lower than the interest rate, which speeds up the generation of losses. Components of the degree of financial leverage can be seen on the following chart:
Chart 1. Degree of financial leverage components
As shown on the chart, degree of financial leverage can be computed by multiplying its two main components, with tax corrector taken into account. Tax corrector shows the degree of financial leverage depending on the level of the profit tax rate.
Level of connected risk is characterized by degree of operating leverage. It reflects positive effect of return on assets and return on equity increase caused by the sales volume growth and debt capital involvement. At the same time it reflects the risk of profitability decline and generation of loss. Let us proceed to an example of degree of financial leverage computation with use of above-mentioned formula:
|Debt Capital||USD||35 087.9|
|Total Capital||USD||80 967.4|
|Operating Income||USD||23 478.1|
|Debt capital interest rate||%||12.5|
|Debt interest amount||USD||4 386.0|
|Profit tax interest rate||%||24.0|
|Taxable income||USD||19 092.1|
|Profit tax amount||USD||4 582.1|
|Net Income||USD||14 510.0|
|Return on equity||%||31.6%|
|Degree of financial leverage (DFL)||%||9.6%|
Degree of financial leverage computation (download)
Computation results are presented in the table above. They show that involving debt capital gave company the ability to increase its return on equity by 9.6%.
Financial leverage measures the possibilities of increasing return on equity and risks of financial sustainability loss. The higher debt capital share is, the more sensible net income is to changes in profit. Thus, with additional involvement of debt return on equity may grow in case following is true:
ROA > i
ROE > ROA
ΔROE = (ROA - i) * (D ÷ E)
As an assumption, it is reasonable to involve debt capital if return on assets in higher than the interest rate. In this case increasing the share of debt capital would increase return on equity. At the same time, the company should track differential of financial leverage because with increase of debt to equity ratio creditors are likely to compensate their risk with increase of the debt capital interest rate. Differential reflects the creditor’s risk: the higher it is, the lower the risk is. Differential value must be positive, and the optimal value of degree of financial leverage lies between 30% and 50% of return on assets. This can be explained with a strict dependence between effect of financial leverage and various risks (credit, dividends risks).