Hope the studying is going well… having an issue with the Fin Leverage = avg total assets/ avg total equity. In my undergrad we would use liabilities instead of assets because is leverage not the use of debt to further enhance your ROE For example if a company can recieve leverage for less than there cost of debt then leverage makes sense and also creates a tax shield. Can someone explain why the CFA uses assets in the numerator instead of LIBS
A/E = 1 + L/E since A = E+L so it is the same thing. L/E is included if you used A. no particular reason why A is used instead of L (at least I am not aware of any reason). But intuitively A/E explains that high leverage ratio means u have a higher amount of Debt. It creates a tax shield - but also has the unwanted complications arising when u as a company fall upon bad times. Since this would cause ur profits to be highly “magnified” when times are good, and your losses are highly magnified as well, when times are bad.
The only time I’ve seen leverage defined as A/E is as part of the DuPont decomposition (to match the A in the denominator of the asset turnover term). Everywhere else in finance, leverage is defined without A. But it’s hardly a standard definition; all of these ratios are frequently used as “leverage”: D/E D/C D/MC D/EBITDA