The first step in determining financial leverage gain for a business is to calculate a business’s return on assets (ROA) ratio, which is the ratio of EBIT (earnings before interest and income tax) to the total capital invested in operating assets.
When a business realizes a financial leverage gain for the year, this means that it earns more profit on the money it has borrowed than the interest paid for the use of that borrowed money. A good part of a business’s net income for the year could be due to financial leverage.
Here’s how to calculate the return on assets (ROA) ratio:
EBIT ÷ Net operating assets = ROA
This equation uses net operating assets, which equals total assets less the non-interest-bearing operating liabilities of the business. Net operating assets represent the total amount of capital raised from debt and equity.
Compare ROA with the interest rate: If a business’s ROA is, say, 14 percent and the interest rate on its debt is, say, 6 percent, the business’s net gain on its debt capital is 8 percent more than what it’s paying in interest.
There’s a favorable spread of 8 points (one point = 1 percent), which can be multiplied times the total debt of the business to determine how much of its earnings before income tax is traceable to financial leverage gain.
In the figure below, notice that the business has $100 million total interest-bearing debt: $40 million short-term plus $60 million long-term. Its total owners’ equity is $217.72 million. So its net operating assets total is $317.72 million (which excludes the three short-term non-interest-bearing operating liabilities). The company’s ROA, therefore, is:
$55,570,000 EBIT ÷ $317,720,000 net operating assets = 17.5% ROA
The business earned $17.5 million (rounded) on its total debt — 17.5 percent ROA times $100 million total debt. The business paid only $6.25 million interest on its debt. So, the business had $11.25 million financial leverage gain before income tax ($17.5 million less $6.25 million).
ROA is a useful ratio for interpreting profit performance, aside from determining financial gain (or loss). ROA is a capital utilization test — how much profit before interest and income tax was earned on the total capital employed by the business. The basic idea is that it takes money (assets) to make money (profit); the final test is how much profit was made on the assets.
If, for example, a business earns $1 million EBIT on $25 million assets, its ROA is only 4 percent. Such a low ROA signals that the business is making poor use of its assets and will have to improve its ROA or face serious problems in the future.