How to Determine Financial Leverage for Investors
A company's degree of financial leverage is the amount of the company that's funded using finances with fixed repayments, such as loans. Pretend for a moment that you’re deciding whether or not to buy stock in a company. Now pretend that this company has borrowed money to obtain capital.
Investors, both real and pretend, measure financial leverage like this:
Here’s how to use this equation:
Find both the EBIT and the net income on the income statement near the bottom.
Divide the EBIT by the net income to find the financial leverage.
The goal of this measurement is to determine how much of a company’s earnings are being taken up by the interest incurred by the company’s loans. Investors receive the amount of income they earn by owning shares in the company either as dividends or as increased stock value. So if the company’s earnings are being eaten up because the company didn’t utilize debt properly, that’s a bad thing for investors.
Debt isn’t necessarily a bad thing, though. If the company generates more earnings with the capital it raises by taking loans than the price of its interest payments, then the ratio of earnings to interest will increase, thus decreasing the company’s financial leverage.
If the debt payments are higher than the earnings created using borrowed capital, then the financial leverage ratio will increase. As you can see, financial leverage is an excellent measure of how well a company utilizes debt.