Hi Guys, A quick question: - Can you give me an interpretation of the financial leverage ratio? - Compared to a benchmark, for a company, is it better to have a higher or lower financial leverage ratio? If yes, why?
Thanks
Assuming everything else is the same between two companies, the one with the higher financial leverage (assets/equity) will generate higher ROE, which “in a vacuum” is a good thing.
Theoretically, I’m tempted to think it all comes down to maximizing shareholder value. Financial leverage can certainly magnify returns for shareholders, but too much of it can also increase the chances of financial distress, which can destroy value. Finding the right mix of debt and equity and how it may change over the life cycle of a business/industry is important to maximize value I think.
With that said, I don’t think there is a hard and fast rule of what constitutes a better or worse financial leverage ratio, it’s a multifaceted question that depends on a variety of factors.
Maybe someone else can add some more.
There are many ways to interpret leverage: the one used in DuPont breakdown analysis is calculated as Asset/Equity
The higher the leverage; the less your assets is composed of equity, meaning your debt funds more portion of your assets.
other ways to measure leverage include but not limited to : Debt/Assets, Debt/Equity, Degree of Financial Leverage (DFL)
Higher leverage will increase financial risk. From a credit point of view, higher leverage is always bad. An equity investor could view this as good or bad.
This is a great point to also consider, optimal leverage means different things to debt and equity capital providers.
So if two with same ROE, one with higher leverage is relatively nothing?
Everything else held constant, if the ROE is the same, you’d make the case that the firm with higher leverage is underperforming. You could use the three- or five-factor DuPont method to decompose what’s driving the underperformance despite leverage being higher. Might be poor sales, poor operating margins, etc.