Hey guys, It’d be great if you could help me out on this one. So I always understood financial leverage ratio to be ( Debt/ Equity ) and have used it in some problems and it has worked out. But in Stalla Review they describe financial leverage ratio as (Assets / Equity) and use it for things such as the Cash Conversion Cycle. where CCC = Profit Margin x Total Asset TO x Financial Leverage Ratio = NI / Sales x Sales / Assets x Assets/ Equity …but everywhere I’ve read and what I learned always says that Financial Leverage Ratio is Debt / Equity… Anyone clear this up for me? Thanks
both are the same… TA/Equity = (Debt + Equity)/Equity Since TA = Liabs(Debt) + Equity. So you know FL as Debt / Equity CFAI calls it: TA/Equity = (1+Debt/Equity) does that make sense?
yea but in the end FL is D/E +1 not D/E right?
CFAI calls Financial Leverage= TA/Equity => also called Equity Multiplier. And Debt/Equity => is called just that.
Both ratios are valid due to their inherent relationship, and any change in one of the variables will impact the other. It might be easier to understand with an illustration: A = L + E, where A = 3, L =2, E =1 D/E is 2 (debt is twice as much as equity) and A/E is 3 (assets are three times the equity) If the debt increases to say 3 then assets are no longer 3 times equity. Asset must either (i) increase to 4 (equity will remain as 1 and asset will go up by 1) OR (ii) to a large number (in cases where equity diminishes rapidly below 1, and asset inceases by the new equity amount). In either case, one can make out how leveraged the firm is.