Name: Financial leverage explained
Uploaded: 2020-03-03T08:50:23.000Z
Duration: 5 min 4 s
Description: Thousands of YouTube videos with English-Chinese subtitles! Now you can learn to understand native speakers, expand your vocabulary, and improve your pronunciation...

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

Basic passive voice

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

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

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.

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.

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

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

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.

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

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

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

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

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

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

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 word “could” in 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 can “multiply” gains….

and wipe out equity in case of unexpected losses.

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