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Financial Leverage: Definition, Formula & Calculation Video

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  • 0:00 What Is Financial Leverage?
  • 0:34 How Does Financial…
  • 3:36 The Equity Multiplier
  • 6:02 Lesson Summary
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Lesson Transcript
Instructor: Jay Wagner
New investors often have trouble understanding how their stock can earn a higher return than the company that issued the stock earned. The answer is financial leverage, which is explained in this lesson.

What Is Financial Leverage?

We're all familiar with the lever. It helps multiply the strength of the user (this is called leverage), enabling them to move much heavier objects than they normally could. Most of us have probably even played on a lever in the form of a teeter-totter. Like the physical lever applies leverage to multiply the strength of the user, financial leverage multiplies a company's financial strength with regard to common stockholders, allowing them to provide those stockholders with a larger return than they could have without leverage.

How Does Financial Leverage Work?

Besides common equity (common stock and retained earnings), companies can use debt, preferred stock, and leases to finance their assets. These three additional financing sources tend to have fixed costs that are lower than the earnings the company receives from the assets. As a result, they lever the return on the common stockholders' investment upward. Let's look at an example of this in action.

Rick Boswell decides to open a business, investing $100,000 of his own money. In the first year, the business earns $40,000 before taxes. The business pays 40% in taxes, which adds up to $16,000, and leaves Rick with $24,000 in net income, a 24% return on his investment.

In the second year, the company takes on $20,000 of 7.5% debt and uses the money to buy back $20,000 worth of Rick's equity. Again, the company earns $40,000, but before paying taxes, it pays $1,500 in interest on the debt. This leaves $38,500 in taxable income and $23,100 in net income. The company's return on investment is only 23.1%, but Rick's return on his now $80,000 equity investment is 28.875%. In finance, it's common to round to two decimal places, so we would say 28.88%. Notice that even though the company's return is lower than before, Rick's is higher.

In the third year, the business sells $10,000 worth of 10% preferred stock, again using the proceeds to buy back some of Rick's stock. Everything remains the same as the second year, except now $1,000 of preferred dividends must be paid from the $23,100 net income, leaving $22,100 for Rick. However, Rick's investment is now only $70,000, so that provides him with a 31.57% return on his investment!

Finally, in the fourth year, the business leases $10,000 worth of assets for 5 years, paying $2,571 (9% interest included) each year and allowing Rick to take $10,000 out of the business in exchange. There is $900 in interest on the lease, reducing taxable income to $37,600, net income to $22,560, and leaving $21,560 for Rick, a 35.93% return on his now $60,000 investment.

You may have noticed that interest on the debt and lease was deducted before taxes but the dividends paid to the preferred stockholders were deducted after taxes. This is an important point to remember when evaluating financial leverage; interest is tax deductible, dividends are not. This makes the real (after tax) cost of debt and leases lower than their stated costs.

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