How To Calculate Financial Leverage? Here’s The Formula!
A lot of investors using financial leverage to fund up a business. If you plan to do so, the crucial step you have to do is calculate the financial leverage. But how to choose and calculate the right leverage for you? Learn it here!
Understanding Financial Leverage
Financial leverage is a money that being used by investors to fund the company with hope of gaining income. To determine how much money you need or how to achieve it can be done depending on your goals.
Financial Leverage Formula
There are several formulas you can choose to calculate the leverage. Check them below and see which formula that suit with your goals the best.
1. Debt-to-Equity Ratio
The debt-to-equity ratio compares the amount borrowed by the corporation to the amount raised by private investors or shareholders. The formula will be :
Debt-to-Equity Ratio = Total Debt / Total Equity
Instead of looking at what the company owns, a company can measure leverage by focusing on how assets have been financed. It means the company has more debt and equity. However, this does not always imply that a corporation is highly leveraged.
2. Debt-to-Assets Ratio
A company’s leverage can be calculated by determining what percentage of its assets were purchased using loans. To calculate the equity-to-assets ratio, divide the debt-to-assets ratio by one. A high debt-to-assets ratio indicates that a corporation has used leverage to finance its assets.
Debt-to-Assets Ratio = Total Debt / Total Assets
3. Debt-to-EBITDA Ratio
Debt-to-EBITDA = Total Debt / Earnings Before Interest, Taxes, Depreciation, and Amortization
A corporation might also compare its debt to its income in a given period. Because the corporation will want to know the debt in relation to the controlled operating income, EBITDA is commonly used instead of net income. A corporation with a high debt-to-EBITDA ratio is carrying a lot of weight in comparison to how much money it generates. The higher the debt-to-EBITDA ratio, the more leverage a corporation carries.
4. Equity Multiplier
Although debt is not directly incorporated in the equity multiplier, it is included because total assets and total equity are both closely related to total debt. The equity multiplier aims to assess a company’s ownership weight by examining how assets have been financed. A corporation with a low equity multiplier has used stock to fund a major share of its assets, indicating that it is not excessively leveraged. The formula for this method will be :
Equity Multiplier = Total Assets / Total Equity
The equity multiplier can be calculated by dividing a company’s total assets by its entire equity. Once calculated, the return on equity is calculated by multiplying the financial leverage by the total asset turnover and the profit margin.
5. Degree of Financial Leverage (DFL)
DFL is usually being used in fundamental analysis. The degree of financial leverage is evaluated by dividing a company’s earnings per share (EPS) change by its earnings before interest and taxes (EBIT) change over a period. The basic formula is :
Degree of Financial Leverage = % Change in Earnings Per Share / % Change in EBIT
DFL’s purpose is to determine how sensitive a company’s profits per share are to changes in operating income. A greater ratio indicates more leverage, therefore a company with a high DFL is likely to have more variable results.
6. Consumer Leverage Ratio
Consumer Leverage = Total Household Debt / Disposable Income
This formula can be used by companies and even household. Households can employ leverage by taking on debt and using their income to cover interest charges.
Consumer leverage is calculated by dividing a household’s debt by its disposable income. Households with a higher computed consumer leverage have a high level of debt compared to their income and are thus highly leveraged. Customers may have problems obtaining loans if their consumer leverage becomes too high. When households apply for mortgage loans, lenders frequently impose debt-to-income limits.
Which Formula That You Will Apply On?
Now you have know how to calculate the leverage with several formulas. Which one do you think is the best one for you? Before applying the formula, make sure you have understand what is financial leverage and also the advantages of it.
