Financial LeverageA common measure of leverage is simply the Financial Leverage ratio. Financial Leverage =Assets/Shareholders' Equity Think of it like a Mortgage - a homebuyer who puts Rs. 200,000 down on a Rs. 1,000,000 house has a financial leverage ratio of 5. For every Rupee in Equity, the buyer has Rs. 5 in assets. The same holds true for companies. In 2008, a retailer like Trent has a financial leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total assets. (It borrowed the other Rs. 1.1.) Financial Leverage is something you need to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster. Look at the kind of business a firm is in. If it's fairly steady, a company can probably take on large amounts of debt without too much risk because there's only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments. On the flip side, be very wary of a high finacial leverage ratio if a company's business is cyclical or volatile. Because interest payments are fixed, the company has to pay them whether business is good or bad. Rough benchmarks for analysing a firm's
A financial leverage ratio of 2.1 is fairly conservative, even for a fast growing retailer. Its when we see ratios of 4, 5 or more that companies start to get really risky. |
