Financial leverage

The rate-of-debt-to-total-assets ratio is an indicator of the percentage of assets that are financed by creditors and the extent to which financial leverage is employed. This ratio also reflects the importance of borrowed funds and the owner s investment to the creditor, and a large debt percentage is usually viewed as an unfavorable financial condition. Table 9.17 presents the calculation of this ratio. 

Large deferred liability costs High financial leverage Financial complexity Highly relevant Less relevant in US because government has responsibility for waste fuel... 

Nuclear power is commercially more exposed to commodity price risk because it has high fixed costs. If nuclear liabilities are regarded (as they should be) as de facto debt, then British Energy (BE) also had high financial leverage. This made the company s profitability highly sensitive to the price of power. 

Financial risk is in some cases defined as the additional variability in earnings. .. and the additional chance of insolvency. .. caused by the use of financial leverage (Keown etal., 2002). In turn, the financial leverage is the amount of assets of the firm being financed by securities bearing a fixed or limited rate of return. Thus, the degree of financial leverage (DFL) is defined as the ratio of EBIT to the difference of EBIT and the total interest expense I, that is. 

Consider the financial performance shown in Table 3-1 for Amazon.com and Nordstrom Inc. In 2013, Amazon Nordstrom achieved ROE = 274/9,746 = 2.81 percent (613/1,913 = 32.04 percent) and ROA = [274 -l-141 X (1 - 0.35)1/40,159 = 0.91 percent [613 -I-160 X (1 -0.35)1/8,089 = 8.86 percent). The difference between ROE and ROA is referred to as return on financial leverage (ROFL). In 2013, Amazon (Nordstrom had ROEL = 2.81 - 0.91 = 1.90 percent (32.04 — 8.86 = 23.18 percent). ROFL captures the amount of ROE that can be attributed to financial leverage (such as accounts payable and debt). In Amazon s case, a significant portion of the financial leverage in 2013 came from accounts payable rather than debt. Thus, an important ratio that defines financial leverage is accounts payable turnover (APT). 

Financial leverage = Equity multiplier = Total assets/Common equity... 

Leverage is another word for debt. How can debt be used advantageously Remember that companies finance assets and operations with a mix of debt and equity. Debt helps companies earn a greater return for shareholders than if they used only their own money (equity). Consider this example of how financial leverage can be helpful You want to live in a house that you cannot afford. Few people... 

When a company is financed with debt, ROE is found by multiplying ROA by an equity multiplier (a company s financial leverage). As stated earlier, financial leverage is another term for debt and refers to the relative use of equity or debt to finance asset purchases. The equity multiplier will show if the company s use of borrowed money (debt) is driving ROE. 

The next equation is an expanded DuPont equation that shows ROE is a function of three factors (1) profitability, (2) efficiency, and (3) financial leverage. 

Alternately, consider an investor s perspective. An investor might believe that a company with an increasing ROE is aworthwhile investment. However, if ROE increased only because the company took on additional debt, which increased its financial leverage, this bears... 

First, it allows users to isolate what is driving ROA and ROE. Are they driven by the company s ability to earn high profit margins (a measure of operating efficiency), or from its efficient use of assets (measured by total asset turnover), or from its use of debt financing (measured by financial leverage, equity multiplier) ... 

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