A firm's financial leverage is the amount of debt it uses to fund its business in relation to the amount of equity from stockholders. A firm must repay debt to creditors, but does not need to repay equity from stockholders. Using financial leverage allows a firm to purchase more assets and can increase returns for stockholders. However, too much leverage increases the risk that the firm may be unable to repay its debt and be forced into bankruptcy. You can calculate a firm's financial leverage to measure its potential risk to stockholders.
Find the amount of the company's total assets, total liabilities and total shareholders' equity listed on its most recent balance sheet. You can find a public firm's balance sheet in its 10-Q quarterly reports or its 10-K annual reports, which you can obtain for free from the SEC's EDGAR online database. Liabilities are amounts of money a firm owes to others. For example, assume a company has $1 million in total assets, $600,000 in total equity and $400,000 in total liabilities.
Divide the company's total liabilities by its total equity to calculate its debt-to-equity ratio. This shows the amount of debt the firm is using to fund its business for every dollar of equity stockholders have invested. A ratio below 1 means the firm has less debt than equity, which is typically less risky for stockholders. In this example, divide $400,000 by $600,000 to get 0.67. This means that the company has 67 cents of debt for every dollar of equity.
Divide the firm's total liabilities by its total assets to calculate its debt-to-total assets ratio. This shows the percentage of debt the company is using to fund its assets. A lower ratio typically suggests less risk. In this example, divide $400,000 by $1 million to get 0.4, which is equivalent to a 40 percent debt-to-total assets ratio. This means the company is funding 40 percent of its total assets using debt.
Compare a firm's debt-to-equity ratio and debt-to-total assets ratio with the industry averages to determine if the firm is using appropriate financial leverage. A firm with ratios higher than the industry averages may pose additional risk to stockholders.
- Balancing the Accounts image by Julien BASTIDE from Fotolia.com