# Financial Leverage

When developing financial projections for a business plan, it is important to pay close attention to the business’s capital structure. One way of indicating the capital structure is to calculate the financial leverage ratio. This ratio measures the level of debt in relation to the level of owners equity.

The financial leverage formula is the ratio of debt to equity as follows: A business with a high level of debt (referred to as being highly geared) is considered to be more risky. The risk results from the need to pay finance costs before equity owners get their return. However, provided cash and profit are managed correctly, a high level of debt and therefore risk will give greater returns to the owners

So there is a careful balance to maintain between the levels of debt and equity. High leverage will increase the return to the equity owners but the business must have the ability to pay the finance costs (interest and fees) and ultimately to repay the loan principal. In contrast, low leverage will provide a less risky business, but will also produce lower returns for the owners.

## Using Financial Leverage to Increase Equity Returns

As an example, suppose a business is funded entirely from equity (money injected by its owners and retained earnings) of 400,000 and has a net income of 60,000 for the year. In this case the financial leverage is zero, and the return on equity is 60,000/400,000 = 15%.

### Financial Leverage 100%

In contrast suppose we fund the same business with debt and equity in equal amounts. In this instance 200,000 is provided by the owners, and a further 200,000 is provided by a long term bank loan at an interest rate of 6% (debt). The financial leverage calculation is as follows:

```Financial leverage ratio = Debt / Equity
Financial leverage ratio = 200,000 / 200,000
Financial leverage ratio = 100% or 1 or 1:1
```

The business now has interest on the loan to pay of 200,000 x 6% = 12,000. Accordingly, all things being equal, its net income falls to 60,000 – 12,000 = 48,000. However, although the earnings are lower, the return on equity to the owners is now 48,000 / 200,000 = 24%.

The equity owners return has increased. The business earns 15% (60,000/400,000) but only pays the bank 6%, a difference of 9%. So the total return to the owners is 15% on their own money of 200,000 and 9% on the banks money of 200,000 giving a total of 24%. The calculation of this return is as follows.

```Return to owners = Return on own money + Return on debt
Return to owners = 200,000 x 15% + 200,000 x 9% = 48,000
Return on equity  = 48,000 / 200,000 = 24%
```

### Financial Leverage 300%

Finally, if the amount of debt increases even further to 300,000 and the equity provision is 100,000 then the financial leverage is as follows:

```Financial leverage ratio = Debt / Equity
Financial leverage ratio = 300,000 / 100,000
Financial leverage ratio = 300% or 3 or 3:1
```

The business now has interest on the loan to pay of 300,000 x 6% = 18,000. Accordingly, all things being equal, its net income falls to 60,000 – 18,000 = 42,000. Consequently the return on equity is now 42,000 / 100,000 = 42%.

The effect of the higher leverage is to increase the owners return to 42%. The return has increased by 27% on the original return of 15%. Again, the owners have earned 15% on their money but have also earned a 9% return on the banks money. In this instance the debt is 3 times the equity and therefore the financial leverage multiplier is 3. The business has earned an additional 9% x 3 = 27%, giving a total of 42%. The calculation of the return is as follows.

```Return to owners = Return on own money + Return on debt
Return to owners = 100,000 x 15% + 300,000 x 9% = 42,000
Return on equity  = 42,000 / 100,000 = 42%
```

Providing the business can afford to pay the interest and repay the debt when it falls due, then the equity owners continue to earn higher and higher returns as the financial leverage increases.

## The Economy Turns

But what happens when the economy turns and interest rates rise. Suppose the business can now only generate profits of 38,000 instead of the previous 60,000. In addition bank interest rates increase to 12%.

In our business with zero financial leverage, the owners still make a return on equity of 38,000/400,000 = 9.5%. This is lower than before, but the business survives.

For our business with the high financial leverage of 300%. the interest is now 300,000 x 12% = 36,000, and the net income is 38,000 – 36,000 = 2,000. The return on equity is now 2,000 / 100,000 = 2%.

The equity owners return has decreased because the business earns 9.5% but pays the bank 12% a difference of -2.5%. In this instance the debt is 3 times the equity, the financial leverage multiplier is 3 and the owners have lost 3 x 2.5% = 7.5%. The business’s total return falls to 9.5% – 7.5% = 2% which we demonstrate below.

```Return to owners = Return on own money + Return on debt
Return to owners = 100,000 x 9.5% - 300,000 x -2.5% = 2,000
Return on equity  = 2,000 / 100,000 = 2%
```

Financial leverage can improve the returns to equity owners if the business is profitable, able to cover its interest payments, and has the cash flow to repay the debt principal. However, if there is a downturn in the business, the effect of the high leverage is to amplify the decline in the return on equity to the owners. Eventually if the downturn continues, the business will make a loss, and no longer be able to cover the interest on its debts or the debt repayments. The return on equity will become negative, exacerbated by the high level of leverage, and the business will fail. For this reason, the higher the financial leverage, the more risky the business is perceived to be.

## Leverage and Financial Projections

Producing financial projections requires thought to be given to capital structure and the effect of financial leverage on the business. The aim is to provide a decent return on equity while keeping the risk to a minimum.

Although levels of acceptable leverage vary from industry to industry, a bank would not normally want to lend more than the owners have invested. In this case the financial leverage formula gives a maximum leverage ratio required in the financial projections of 1. In the financial projections template, the financial leverage is indicated on the financial ratios page under the leverage ratios heading as the debt equity ratio.