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The Financial Leverage Ratio in Financial Accounting
A basic decision faced by financial managers is the extent to which a firm should rely on borrowed capital. Shakespeare’s adage "neither a borrower nor a lender be" is poor business advice. It is beneficial for most corporations to rely on debt to some extent, because the interest expense on debt is tax deductible, while dividends paid to stockholders are not. The degree of reliance on debt, or financial leverage, is measured as the ratio of debt to assets:
Financial leverage = Total liabilities / Total assets
Figure 9.8 shows financial leverage ratio calculations for two firms, based on financial reports for 1997. Wendy’s International’s debt is equal to about 39 percent of its total assets. This reflects Wendy’s reliance mainly on the retention of its earnings to finance its growth. Seacoast Banking Corporation provides a dramatic contrast; borrowed capital is equal to more than 91 percent of its total assets. This reflects the fact that Seacoast Banking is engaged in the banking industry. Banks accept deposits from customers and report substantial liabilities for future withdrawals.
Figure 9.8 - Financial Leverage Ratio Calculations
The lesson to be learned in comparing Wendy’s and Seacoast Banking in Figure 9.8 is that comparisons of financial leverage ratios across companies in different industries must be undertaken with caution. To some extent, differences in financial leverage reflect management’s willingness (or reluctance) to rely on borrowed capital. To a large extent, however, financial leverage is determined by industry characteristics and practices.
Financial leverage ratios are widely used by analysts to assess the risks of debt and equity securities. Firms with debt percentages that are substantially above their industry averages tend to have a higher likelihood of default on debt payments. As a result, high financial leverage is associated with lower bond quality ratings and therefore higher borrowing (interest) costs. Equity investments have also been found to be riskier for firms with high financial leverages. The share prices of highly leveraged firms tend to be more volatile than the share prices of firms with lower financial leverage.
Ratios in Shareholders' Equity
Related Shareholders' Equity Topics
Transactions Affecting Shareholders’ Equity
Analysis Based on Shareholders' Equity
