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  • What is financial leverage?

  • Financial leverage is a story of assets and their returns on one side, and the way the

  • assets are financed on the other side.

  • The concept of financial leverage can be applied to companies, investment portfolios, and even

  • to the house you own.

  • In this example, we look at a factory with $1 million in assets (buildings, machines,

  • inventory, etcetera).

  • These assets generate an annual net income of $100,000.

  • The return on assets is therefore 10%, $100K in net income divided by $1 million in assets.

  • How are these assets financed?

  • Let’s assume the assets are financed fully by equity, shareholder capital.

  • $100K net income divided by $1 million in equity is 10% return on equity.

  • So far, so good.

  • Equity is not the only way to finance assets.

  • You could also go to the bank for a loan.

  • How about financing the assets 50% with equity, and 50% with debt.

  • Debt hardly ever comes for free, let’s assume the net income drops to $80,000 due to the

  • interest charged.

  • Return on assets is now 8%: $80,000 net income divided by $1 million in assets, which is

  • lower than the 10% we had before.

  • Return on equity goes up: $80,000 in net income divided by $500,000 in equity is 16%.

  • This is the effect of financial leverage!

  • Return on equity was 10% when the assets were financed fully by equity, and return on equity

  • is 16% when the assets are financed 50/50 with equity and debt.

  • How about taking that one step further.

  • What if we finance the assets with $200,000 in equity and $800,000 in debt?

  • Net income drops to $68,000, and return on assets drops accordingly to 6.8%.

  • Return on equity however goes up dramatically.

  • $68,000 in net income divided by $200,000 in equity

  • generates a return on equity of 34%!

  • One more step.

  • What if we finance the assets with only $100,000 in equity and a massive $900,000 in debt (assuming

  • you can find a bank that is willing to grant or arrange a loan

  • with that kind of financial leverage)?

  • Net income drops to $64,000, and return on assets drops accordingly to 6.4%.

  • Return on equity goes up dramatically.

  • $64,000 in net income divided by $100,000 in equity

  • generates a return on equity of 64%!

  • Let’s summarize these four financial leverage scenarios, with the very important disclaimer

  • that we are assuming a very linear and very stable world.

  • In this specific example, $1 million in assets fully financed with equity generate 10% return

  • on assets and 10% return on equity.

  • The same assets financed 50/50 between equity and debt, generate 8% return on assets and

  • 16% return on equity.

  • The financial leverage is 2: for every dollar of equity, there are two dollars of assets.

  • If financial leverage is 2, then ROE is 2 times ROA.

  • When we go to 20% equity and 80% debt, ROA drops to 6.8% while ROE jumps to 34%.

  • The financial leverage is 5: for every dollar of equity, there are five dollars of assets.

  • If financial leverage is 5, then ROE is 5 times ROA.

  • It looks like the higher the financial leverage, the higher the return on equity.

  • When we go to 10% equity and 90% debt, ROA drops to 6.4% and ROE could skyrocket to 64%.

  • The financial leverage is 10: for every dollar of equity, there are ten dollars of assets.

  • If financial leverage is 10, then ROE is 10 times ROA.

  • Why do we mention the wordcouldin one of the previous sentences?

  • Well, real life can be far more volatile than a nice clean example on paper.

  • What if the $64,000 net income turns into an unexpected loss of $200,000?

  • In a high financial leverage situation, this completely wipes out the existing equity.

  • Either the shareholder urgently contributes more equity to the company, or the bank will

  • take possession of the assets, which were the collateral for the loan.

  • Financial leverage canmultiplygains….

  • and wipe out equity in case of unexpected losses.

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  • Thank you.

What is financial leverage?

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