Definition
Financial leverage uses borrowed money to increase potential returns. While it can amplify profits when returns exceed borrowing costs, it also amplifies losses and increases bankruptcy risk. The equity multiplier (assets/equity) measures financial leverage.
Formula
Degree of Financial Leverage = % Change in EPS / % Change in EBIT
Example
A company with $500M assets and $200M equity has 2.5x leverage. If ROA is 8%, ROE is 20% (8% × 2.5). But in a downturn, losses are also multiplied.
FAQ
What is Financial Leverage?
The use of debt to amplify returns on equity.
How do you calculate Financial Leverage?
A common formula for Financial Leverage is: Degree of Financial Leverage = % Change in EPS / % Change in EBIT
Why is Financial Leverage important?
Financial Leverage helps investors evaluate fundamental analysis and make more informed decisions.