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Financial Leverage Ratio

Analyzing Firms

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The Financial Leverage Ratio compares assets with equity and is a modification of the Debt to Equity Ratio. If assets are equal to equity, the financial leverage ratio has an output of one, which is the lowest it can go. This means the company is paying for all of its assets with shareholder investments and has no debt. If the ratio is higher than one, this means that the firm has more assets than equity. Since assets can only be paid for with debt or equity, the firm must be using debt to pay for assets. The higher the ratio, the more assets the firm is purchasing without using equity and the more debt is being employed to purchase assets. This is riskier than using lower amounts of debt. The financial leverage ratio allowable for firms changes from industry to industry. For certain firms, such as banking, high leverage ratios are allowable since their collateral is extremely liquid and returns on assets are typically high. For other firms, which have to manufacture inventory or grow produce, there is low liquidity in their returns.

Financial Leverage Ratio

If a firm earns a higher return than the interest rates on its debt it can use debt to finance its activities. This is risky. If the firm hits a downturn its rate of debt will exceed the profits and the firm will have to pay out of its retained earnings or equity. This will continue until the performance of the firm improves or the firm goes bankrupt. You will need to ensure that the rate of return on assets exceeds the interest rates the firm is charged for its debts.

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