Financial leverage ratio is a financial ratio that indicates a company's debt situation. Financial leverage ratio expresses how much of the company's total assets are financed by debt. Financial leverage ratio is used to measure the company's debt burden and financial risk.
How is financial leverage ratio calculated?
Financial leverage ratio is calculated by dividing the company's total debt by its total assets. The formula is:
Financial Leverage Ratio = Total Debt / Total Assets
For example, let's say a company's total debt is 500,000 TL and its total assets are 1,000,000 TL. In this case, the financial leverage ratio is calculated as:
Financial Leverage Ratio = 500,000 / 1,000,000 = 0.5
This result indicates that half of the company's assets are financed by debt. The higher the financial leverage ratio, the higher the company's debt burden and financial risk.
What are the advantages and disadvantages of financial leverage ratio?
The advantages of financial leverage ratio are:
- If the return on debt-financed assets is higher than the cost of debt, it increases the company's return on equity.
-The cost of debt is generally lower than the cost of equity. Therefore, using debt reduces the company's cost of capital.
- Interest expenses on the debt are tax deductible. This increases the company's pre-tax profit.
The disadvantages of financial leverage are:
- If the return on debt-financed assets is less than the cost of debt, it reduces the company's return on equity.
- Fixed payments must be made to repay the debt. This negatively affects the company's cash flow.
- Excessive use of debt increases the company's risk of bankruptcy.
What is the ideal level of financial leverage ratio?
The ideal level of financial leverage ratio varies depending on factors such as the sector in which the company operates, its size, profitability and growth potential. In general, it is preferred that the financial leverage ratio be between 0 and 1. However, higher or lower financial leverage ratios may also be seen in some sectors.
How can we improve financial leverage?
The following methods can be applied to improve the financial leverage ratio:
- Increasing equity capital by increasing the company's profits or reducing its expenses.
- Reducing debt by selling or renting the company's assets.
- To increase or decrease the equity capital of the company by issuing new shares or repurchasing existing shares.
- To increase or decrease the company's debt by taking on new debt or repaying existing debt.