Financial Leverage Index

The financial leverage index is a solvency ratio that measures the proportion of a company’s debt compared to its equity that is used to make money and produce income.

It is a gauge used to determine how well or (in some cases badly) a business is utilizing its debts. It is a measure of business’ return on equity (ROE) against its return on assets (ROA). But what exactly is a company’s return on equity and what is a company’s return on assets?

ROA measures how much a company is using its assets to generate profits. ROE, also known as return on net worth is a measure of how a business replenishes each dollar of a shareholder’s equity that is used. It displays an overall summary of a business capital structure and the leverage incorporated into it.

In simpler terms, let’s say you want to start a business and have just 30% of the total capital. You would get an investor to invest the remaining 70%. Now, this business yields 20% of the capital after taxes. But you also have to pay back the investor with an interest of 7%.  If the capital was 100 dollars that means you still have 13 dollars after paying interest. But you put in only 30 dollars which means 43.3% interest on your 30 dollars. So this means that the leverage helped you increase about 23% return on shareholder’s equity.

Financial Leverage Index Formula

$$Financial\: Leverage\: Index = \dfrac{Return\: on\: Equity}{Return\: on\: Assets}$$

But the return on equity and the return on assets most times need to be determined as well before calculating the financial leverage index. You can see this in the following formulas:

$$Return\: on\: Equity = \dfrac{Net\:Income}{Shareholder's\:Equity}$$

$$Return\: on\: Assets = \dfrac{Net\: Income}{Total\: Assets}$$

This formula is used to determine how much return will be ideal for a shareholder’s investment. It will tell if a business can meet that profit. The formula makes use of business financial data like net worth, net income, total assets, total equity, gross income, and dividends. Financial leverage index is also the scale that is used to assess the value of a single share that is finding out how much profit is generated from debts which are profits relative to equity.

Before investing in common stock (as this affects common stockholders more than preferred stocks), investors are generally interested in the financial leverage index. They use it to find out about the amount of leverage a company uses to make income.  They tend to go with companies that have a higher result over those that seem to be managing their Financial Leverage Index quite poorly.

Financial Leverage Index Example

Now, let’s assume that you are a finance manager. A client is looking to buy shares in a company that produces cosmetics. You are requested to analyze the company and decide if the price of the shares and the interest rate are fair and if it will be a good investment. After researching the company you find the following numbers (in thousands):

Net income: $5,000

Total assets: $24,000

Shareholders’ equity: $9,000

Next we need to determine the return on equity and the return on assets before calculating the financial leverage index.

$$Return\: on\: Equity = \dfrac{5{,}000}{9{,}000} = 56\%$$

$$Return\: on\: Assets = \dfrac{5{,}000}{24{,}000} = 21\%$$

Now we can use the financial leverage index formula:

$$Financial\: Leverage\: Index = \dfrac{56\%}{21\%} = 2.67$$

In this case, the financial leverage index would be 2.67. In all businesses, we want the amount of return on assets to be proportional to the return on equity which means that the higher return on the assets, the higher the return on equity. 

In the example above, you compared the return on equity to the return on assets and the result showed that the company had a return on equity that was 267 times higher than the return on assets. 

This indicates that the ratio of the equity base is smaller than the asset base which means the business is making an excellent job of leveraging returns to its shareholders and will be a great investment.

Financial Leverage Index Analysis

Financial leverage index is very important and can be used as a tool to decide how well the business is doing. It can shine a light on the areas that need adjusting. The Leverage Index can also tell if a particular brand is profitable to a company or not. It not only provides a guide to investing, but it also helps determine sources of finance that can be best used by a firm.

When most businesses are looking to expand, the financial leverage index is essential to the operations for the business expansion and puts constraints in place to protect the business and serve as a gauge such that once the financial leverage index is below a particular number, cutbacks are made.

But determining the financial leverage index lower limit is a delicate matter especially when the business is taking a huge risk or treading unknown territories. However, it is advisable to exercise caution when dealing with financial leverage indexes as it escalates the discrepancy in expected returns. This means that the fixed interest payments would later pose a bigger issue if targets are not met or the business runs through a hiccup.

When looking at a company’s financial leverage index, keep this point in mind. If the financial leverage index is rising, this means that the debts acquired by the company are what is used to produce more profit and not from its accounts. 

The increasing index indicates that additional debt has been beneficial to the company. But if it is going downwards, it is an indicator that loans have not been very beneficial to the company and one needs to take a closer look at the company finances and scrutinize.

Financial Leverage Index Conclusion

  • The financial leverage index is a measure of the proportion of the company’s debt compared to equity
  • It is a gauge used to determine how well or poorly a business is utilizing its debts.
  • The formula for financial leverage index requires two variables: return on equity and return on assets.
  • To calculate return on equity and return on assets, three variables are needed: value of vet income, value of total assets and total shareholder’s equity.
  • The greater financial leverage index is than one, the more it is doing an impressive job of utilizing its debts and is proportional to how large the return on equity is than the return on assets.

Financial Leverage Index Calculator

You can use the financial leverage index calculator below to quickly financial leverage index by entering the required numbers.

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