Fra doubt....

CFA Level II
#1

Please explain me this concept… Financial leverage ratio= Avg total assets/Avg total equity This ratio measures the amount of total assets supported by each dollar of equity. For example a ratio of 2 indicates that each dollar of equity supports $2 worth of assets. Tha higher the leverage ratio,the more leveraged(dependent on debt for finance)the company… My doubt is if the ratio is high isnt that good for the company as 1 dollar of equity supports more dollars worth of assets… Thanks

#2

I would look at it as a gap not supported by equity thereby supported by debt

#3

Your picture is incomplete. In your example above, if the ratio is 2, it means two things:

  1. $1 of equity supports $2 of assets.

  2. The remaining $1 comes from debt.

So as the ratio rises, equity support grows weaker. Let’s say the ratio is 4. This means $1 of equity supports $4 of assets - your support is getting weaker. The remaining $3 comes from debt - you’re more levered.

Hope this helps.

#4

Ya Aether…that truly helped…

thanks for the concept

#5

It also depends on what you mean by good. Higher financial leverage = Higher ROE but also higher risk.