Financial leverage explained
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- เผยแพร่เมื่อ 7 มี.ค. 2019
- What is financial leverage? Financial leverage is a story of assets and their returns on one side, and the way the assets are financed on the other side. The concept of financial leverage can be applied to companies, investment portfolios, and even to the house you own. In this example, we look at a factory with $1 million in assets (buildings, machines, inventory, etcetera). These assets generate an annual net income of $100,000. The return on assets is therefore 10%, $100K in net income divided by $1 million in assets. How are these assets financed? Let’s assume the assets are financed fully by equity, shareholder capital. $100K net income divided by $1 million in equity is 10% return on equity. So far, so good.
Equity is not the only way to finance assets. You could also go to the bank for a loan. How about financing the assets 50% with equity, and 50% with debt. Debt hardly ever comes for free, let’s assume the net income drops to $80,000 due to the interest charged. Return on assets is now 8%: $80,000 net income divided by $1 million in assets, which is lower than the 10% we had before. Return on equity goes up: $80,000 in net income divided by $500,000 in equity is 16%. This is the effect of financial leverage! Return on equity was 10% when the assets were financed fully by equity, and return on equity is 16% when the assets are financed 50/50 with equity and debt.
How about taking that one step further. What if we finance the assets with $200,000 in equity and $800,000 in debt? Net income drops to $68,000, and return on assets drops accordingly to 6.8%. Return on equity however goes up dramatically. $68,000 in net income divided by $200,000 in equity generates a return on equity of 34%!
One more step. What if we finance the assets with only $100,000 in equity and a massive $900,000 in debt (assuming you can find a bank that is willing to grant or arrange a loan with that kind of financial leverage)? Net income drops to $64,000, and return on assets drops accordingly to 6.4%. Return on equity goes up dramatically. $64,000 in net income divided by $100,000 in equity generates a return on equity of 64%!
Let’s summarize these four financial leverage scenarios, with the very important disclaimer that we are assuming a very linear and very stable world. In this specific example, $1 million in assets fully financed with equity generate 10% return on assets and 10% return on equity. The same assets financed 50/50 between equity and debt, generate 8% return on assets and 16% return on equity. The financial leverage is 2: for every dollar of equity, there are two dollars of assets. If financial leverage is 2, then ROE is 2 times ROA. When we go to 20% equity and 80% debt, ROA drops to 6.8% while ROE jumps to 34%. The financial leverage is 5: for every dollar of equity, there are five dollars of assets. If financial leverage is 5, then ROE is 5 times ROA. It looks like the higher the financial leverage, the higher the return on equity. When we go to 10% equity and 90% debt, ROA drops to 6.4% and ROE could skyrocket to 64%. The financial leverage is 10: for every dollar of equity, there are ten dollars of assets. If financial leverage is 10, then ROE is 10 times ROA. Why do we mention the word “could” in one of the previous sentences?
Well, real life can be far more volatile than a nice clean example on paper. What if the $64,000 net income turns into an unexpected loss of $200,000? In a high financial leverage situation, this completely wipes out the existing equity. Either the shareholder urgently contributes more equity to the company, or the bank will take possession of the assets, which were the collateral for the loan.
Financial leverage can “multiply” gains…. and wipe out equity in case of unexpected losses.
Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better #investing decisions. Philip delivers #financetraining in various formats: TH-cam videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!
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Enjoyed this video? Then subscribe to the channel, and find out more about how financial leverage fits into the Return On Equity (ROE) calculation th-cam.com/video/6fA5N4giHrM/w-d-xo.html
Leveraged is the bubble in an economy collapse.
Leveraged is the noun. Bubble is a noun. The same noun.
Stop blaming krakens on our economic bubble. There are people who con our banking system called leveraged and need to be arrested. It's in their taxes.
Why would we let anyone create an economic bubble? AKA leveraged.
My landlord is using a not-for-profit mortgage banking to rent to me in a for-profit banking from. This is a con job.
The con; borrow from a not-for-profit bank (such as a mortgage) and at the same time, loan money in a for-profit banking. AKA leveraged, AKA a economic bubble.
One can't have a Cognitive dissonances in borrowing money from a not-for-profit bank than at the same time be lenders in a for-profit banking. This is fraud.
This is the bubble in an economy that colaspes. This is the Glass-Steagall Act..
One should not have a cognitive dissonance. One receives the same interest rates on their mortgage and that in their retirement.
Otherwise. Everyone of us can be $1 trillion leveraged.
Why is my landlord only $1 million leveraged?
Why am I renting from someone with a mortgage? No krakens. Arrest my landlord for being leveraged, borrowing money from not-for-profit banking and lending to a for-profit banking.
Love this story about Financial Leverage. Makes so much sense of how financial leverage impacts net income and return on equity. Thank you.
Hello Alejandra! Thank you very much for the kind words. Yes, financial leverage can be a great thing when things go well, but can REALLY hurt when things go dramatically wrong.
Phenomenal video! Amazing teaching skills. You’ve just skyrocketed your brand equity.
Thank you very much for the kind words, Deepansh! Enjoy the videos on my channel (~160 in total!), and please share with friends and colleagues. :-)
Now I can understand why some companies suspiciously (till now) have a huge ROE. Thanks for the education !!
You're welcome! :-) I think you will like my ROA example as well: th-cam.com/video/2j8bfR8KqJ0/w-d-xo.html Sometimes it's not financial leverage, but an item in the income statement, or the assets side of the balance sheet, that produces unusual results.
Yeah cos they are up to their neck in debt
muy bien explicado, lo haces muy facil, gracias por compartir, es un placer tener un canal con este contenido, gracias
THANK YOU SO MUCH!!!!! You made it so simple and easy to understand!! I can't thank you enough!
Wonderful to hear that, Thomas!!!! Thank you for watching and commenting.
Where did you come across the term "financial leverage"? Let me know by commenting below!
Derivatives market
Principles of Finance module xD
introduction to finance university module
News on WeWork
@@saurabhmaurya94 That's a fascinating case study! I think you might like my video on IPOs, it covers WeWork and others.... th-cam.com/video/4t62BEH9Ajs/w-d-xo.html
This is super great and easy to follow! Thank you so much 🌸🌸
So happy to hear that! :-) Thank you very much for your comment.
Briliant as usual! So clear and easy...
Thank you! :-)
Thanks for the clean content and explained very neatly
My pleasure!
It is always a fun and esay learning through your channel!! 👍.
Please keep the great work. 👍
Thank you so much, Udaya! It's wonderful to hear that. I am getting ready for some new videos, to be published very soon!
This was amazing! Thank you so much!
You're welcome, Katelyn! Happy to help. Please subscribe to the channel, and share with your friends! I put together a playlist of DuPont analysis / ROE related videos (financial leverage is one of the elements in there) that might help you as well: th-cam.com/video/bhbDDSohJ84/w-d-xo.html
This is so easily explained!! Helped a lot. Thank you
So happy to hear that, Sakshi! Have you seen my other videos about various parts of the DuPont equation (ROE, ROA, ROS, etc.): th-cam.com/video/bhbDDSohJ84/w-d-xo.html
Same logic for a LBO and in trading: load up the boat with debt, beef up the returns. Cuts both ways though.
Yep. And the more you load the boat with debt, the more vulnerable you are when the storm hits.
Thank you I watched this for five times and finally understand...
Excellent!!! Use the new found knowledge to your advantage. 🙂
Best explanation ever for financial leverage 📝
Thank you!!!! :-)
Great video mate, really useful. Thanks a lot
You're welcome! Thanks for the compliment.
Thank so much for your videos.
My pleasure! Thank you for watching and commenting, Luciano!
You are my teacher and physician. Thank you very much.
You are very welcome!!! Happy to help. 😊
This guy's a gift❤️
Thank you, Rohit!
This is really helpful. Thank you very much.
Very happy to hear that, Danica! Thank you for watching and commenting.
Amazing channel for financial lessons! 👍👍👍 Kids are a must to watch this..
Thanks for the kinds words!
Well Explained! Thanks sir!!🙂
You're welcome, Abhiral!
thank you so much Pls continue making these ❤
Happy to help! Will keep making videos if you promise to keep watching them. ;-)
Great Video!
Thank you very much! Glad you enjoyed it.
Thanks a lot!
You're welcome!
Amazingly explained
Glad you think so! That is wonderful to hear.
THANK YOUUUUU!!!
YOU'RE WELCOOOOOOOME!!!! ;-)
Good explanation with examples...
Thanks for the feedback, Saikumar! :-)
Gr8 vid!
Thank you very much!!!
very nice video. Explained it clearly.
Thanks a lot! 🙂
damn son, you nailed it !
Haha, thank you, Vincent!
Such a good explanation, thank you very much. I recently finished my MBA and I want to get more knwoledge in accounting and finance. What are some good books that you reccomend? Thank you very much!
Hello Gerardo! No books, go with real world examples, by picking up annual reports from companies you are interested in (or even better: invested money in) and connect their strategy and "narrative" to their financial statements. Whenever you come across terminology that you need help with, check the videos on my channel! Here are some examples of case studies walking through income statements, balance sheets and cash flow statements: th-cam.com/video/PI9X5Ybek_E/w-d-xo.html
Thanks sir 👍🏻
You're welcome, Mohit! :-)
Buenísimo!
Gracias!!!
tank u my bro
No problem! Use the lesson to your advantage! :-)
Great video .. Do you use any specific software to add such visuals in the content?
Thank you for the kind words! I use PowerPoint and add an audio track: th-cam.com/video/iIMmS-5W3v4/w-d-xo.html For some of the visuals, I take screenshots from annual reports using the snipping tool in Windows 10.
If I were a CEO of a company, I wouldn't "lever" my debt only to raise ROE and drop the net income (maybe others do, I guess), also I personally avoid debting to others
Same here, Surya! Sadly, some CEOs maximize profit while taking on huge hidden risk, and/or take the bonus in the good years, but refuse to pay back that bonus when the business subsequently "blows up".....
Please make a video on operating leverage and combined leverage
Thanks for the suggestion!!!
thank you
You're welcome!!!
How do I put this in practice? Really interested. Where can I study more about it?
If you want to learn more about DuPont Analysis (return on assets, return on equity), then the videos in this playlist will help: th-cam.com/video/bhbDDSohJ84/w-d-xo.html&pp=gAQBiAQB
If you are interested in the risk of taking on too much debt and "blowing up" when overleveraged, then understanding liquidity and solvency are key: th-cam.com/video/XtjS7CfUSsA/w-d-xo.html&pp=gAQBiAQB
great video very much clearity. but how to know assets funded by debt in %
From the company's balance sheet. Here's my calculation for Apple: th-cam.com/video/J_1F8GoLOI8/w-d-xo.html
Please explain
Financial leverage : The magnification of risk and return through the use of fixed cost financing, such as debt and
As evidenced in the video! Watch it and you will understand.
anyone here after archegos ⁉️
Hedge funds go BOOM! ;-)
I know that we can check whether the debt is low or high by comparing to its capital structure and equity. But is there any other ratio or financial metric which can be used to relate company's debt to it earnings or EBITDA, which will tell us whether the company will be able to pay its debt if it has lesser % of equity and larger % of debt.?
And what you think what the ideal Net debt / EBITDA ratio should be (i.e. how much debt a company should take in comparison to its EBITDA)?
Hi Krishan! You could use the interest coverage ratio, but there are some limitations to its use: th-cam.com/video/P19tw3Hb7TA/w-d-xo.html I have no specific "guidelines" for an ideal Net debt / EBITDA ratio, this could depend on the level of maturity of the company and its industry. You could look up some articles in the financial news around debt covenants... sometimes these terms are disclosed publicly. In general, taking on significant amounts of debt increases a company's fragility. On the other hand, companies can accelerate their growth (through more R&D, or more selling and marketing efforts) by borrowing money at fairly low interest rates.
Actually some correction, the $80,000 annual net income would have to be split in the event of leverage as some will go to paying off the loan and the balance to the investor.
Calculating net income happens in the income statement (also sometimes called profit and loss statement): th-cam.com/video/Hq-44PHgAiU/w-d-xo.html while paying down debt and paying dividends occur in the Cash From Financing Activities (CFFA) section of the cash flow statement: th-cam.com/video/xw67FIeVsj8/w-d-xo.html Those are separate things.
So is bigger return on equity (%) seen as better in the financial world? Or is it the opposite?
I assume that the factory owner wants the largest possible net income (100 000$) but do the investors want larger ROE % or largest possible income aswell.
All of the above. But it is wise to ask yourself: where does it come from, is it repeatable, what is the (hidden) risk?
Is this roe/roa method a better way compared to Debt to Equity ratio to figure out how a company finances their assets ?
For example if i get 1.5 from dividing roe/roa , would that effectively mean that the assets are financed by 67% equity then 33% debt ?
I think both of the methods can get you an understanding of the financing structure. I have never consciously divided ROE by ROA before, but you can get some multiples at the end of the video near th-cam.com/video/GESzfA9odgE/w-d-xo.html A multiple of 2 means 50/50 financing between debt and equity. A multiple of 10 means 9-to-1 debt to equity.
Great video. Did you make a video on this topic with a real-life example like alphabet inc? I can't seem to find it.
Thank you, Moizzkhan! I did reviews of the income statement, balance sheet, and cash flow statement of Alphabet Inc: th-cam.com/video/ToE-oggQiqQ/w-d-xo.html I also did an ROE (Return On Equity) analysis, which includes the financial leverage component, of Apple: th-cam.com/video/DQgEoz8izxY/w-d-xo.html as well as ROA (Return On Assets) analysis of Verizon vs Walmart th-cam.com/video/2j8bfR8KqJ0/w-d-xo.html Hope these are helpful for you!
@@TheFinanceStoryteller I watched the Income Stateement, Balance sheet and cash flow statement analysis videos. I'll definitely watch the others you just mentioned. Thank you so much for taking the time to link the videos. Thank you so much. 👍👍
My pleasure! :-)
Isn't leverage defined as debt to equity ratio? In that case at 3:24, the leverage must be 1 right?
Hello Saj! There are several definitions of leverage "in circulation". The definition I use in this video is linked to how it is defined in the DuPont analysis: assets divided by equity. You use debt-to-equity (as in: total liabilities divided by total equity), which would indeed be 1 at that timestamp in the video. Some people use debt-to-equity as interesting bearing debt (in other words excluding accounts payable, accrued liabilities, etc.) divided by equity. Always check the definition carefully when you see any of these calculations!
i dont get the last part..how growth of net income (from 68K up to 200K...) can be called 'a loss' ???
are the brackets symbolize minus (-)??
Hello János! Yes, the brackets symbolize minus. The net income goes from positive $64K (a profit) to negative $200K (a loss).
If there is more return on equity would this mean that the share price will rise?
In general, investors prefer companies with a higher ROE, so demand for the stocks of companies that have a high ROE should be higher. However, ROE is a metric that looks back at historical financial performance. Most of the value of a stock depends on its prospects for the future. If a company achieved a high ROE in the past, then that is not an absolute guarantee for it to repeat that high ROE in the future.
High ROEs explained finally 😆
Thank you, Dilantha! Yes, that's why I love DuPont analysis so much... figure out whether the high ROE comes from operational drivers or from financial leverage! th-cam.com/video/bhbDDSohJ84/w-d-xo.html
But how about the face value of the debt?? At some point you will not only have to pay the low interest, but the big face/par value of the debt, which would reduce substantially your income and make ROE very low?? What am I missing?
Hello Patrick! Yes, at the end of the borrowing period, you pay back the principal amount. This does not have an effect on income. The journal entry for it is debit debt, credit cash. To be able to pay back the loan, you have to generate enough cash from operations, or to take out a new loan to replace the old one. See the video on the cash flow statement th-cam.com/video/mZBjsIYrLvM/w-d-xo.html and the one on cash flow patterns in a business lifecycle th-cam.com/video/UGd2llFBiMA/w-d-xo.html
What if both of these figures (net profit and shareholders equity) are negative and the company has an enormous ROE ratio, what does this tell us?
Then the outcome of the calculation is NMF: Not MeaningFul. It tells you absolutely nothing. Other than the company potentially being in significant financial trouble.
How do you get the numbers for income?
I used 4% after-tax interest on the debt. I took $100K net income when the asset is 100% financed by $1MM equity. So when you move to $500K equity and $500K debt, then the additional interest charge is 4% of $500K = $20K. The net income drops by that $20K to $80K. You could even argue that the interest % needs to go up in a more highly leveraged situation, but I wanted to keep the calculation as simple as possible.
The more you give up on equity and that number rises , is that a bad thing for companies ,as also the ROA went down aswell
Hello Philippe! The bigger the leverage, the bigger the chances of a "blow up".... It might improve ROE in the short term, but if you go out of business then there will no longer be ANY ROE or ROA.
Im sorry for my ignorance, im starting to learn..
What is equity? what does return on equity mean?
Im sorry if its a dumb question.
Those are great questions, for which I have made specific videos to answer them. What is equity th-cam.com/video/Q1z395u60xU/w-d-xo.html What is return on equity th-cam.com/video/6fA5N4giHrM/w-d-xo.html Enjoy!
There is willingness to learn.That's what matters in the end.
how does ROE affects EPS sir? I'm sorry, I'm still confused in connecting those two
ROE is Net Income $ divided by Equity $ (at book value, taken from the balance sheet). EPS is Net Income $ divided by the number of outstanding shares. Same numerator, different denominator. ROE and EPS should be highly correlated (if one goes up, the other is also likely to go up). ROE explanation th-cam.com/video/6fA5N4giHrM/w-d-xo.html EPS explanation th-cam.com/video/TXjkQy5KJog/w-d-xo.html
Could somebody explain to me why, when the scenario is $500K to the shareholder, and $500K to the bank, that the shareholders get ALL the income that the factory is outputting?
(It's at around 1:00 into the video)
There is an interest charge on the debt to the bank, and the shareholders get the "residual income", what is left after you deduct all expenses from revenue: th-cam.com/video/9j8HQg7YxXw/w-d-xo.html
don't we calculate the financial levarage debt/equity
Some people indeed use debt/equity, others assets/equity. Like in many other areas in finance, there is not always agreement on definitions of terms.
Financial leverage is the same thing as Leverage Buyouts?
They are related, but not the same. When a leverage buyout happens, there will always be very high financial leverage. However, not every situation where a company has high financial leverage is a situation where a leveraged buyout occured.
@@TheFinanceStoryteller ok that makes thank you
How does financial leverage work for banks because they are highly levered anyway??
Same way. Bear Sterns blew up in March 2008. Lehman Brothers blew up in September 2008. Too much leverage was a huge factor in it. As we never ever want to have to bail out banks again, the solvency requirements have gone up significantly. For example, when the pandemic hit, financial institutions in many countries were not allowed to pay any dividends to shareholders (temporarily), to keep the equity in the bank in uncertain times.
@@TheFinanceStoryteller So I just read that Lehmann Brothers was 44 times levered at time of bankruptcy. Makes me wonder how they would have gone through the whole winding up process.That would have been a completely different challenge. I am just curious about if there is any ideal financial leverage ratio for banks and non-banks.
In my view, as low as possible. Leverage = fragility.
Why did the net incomes change whenever equitys changed?
As assets are $1MM, and I keep lowering the amount of equity, the amount of debt is growing in each step. The lower the equity, the higher the debt. I used a 4% after-tax interest charge on the debt, that's why the net income drops in each of the subsequent scenarios. My apologies if that was not totally clear when watching the video!
@@TheFinanceStoryteller Thanks, love that you answered
@@TheFinanceStoryteller But isn't there a tax advantage to using debt?
@@BibleGeeek Yep, that's why I am using the after-tax interest charge in the calculation.
Where did the 68k come from?
I used an after-tax interest charge of 4% on $800,000 of debt, which leads to an annual interest expense of $32,000. NOPAT of $100,000 minus interest expense of $32,000 equals net income of $68,000.
I don't understand how the Financial Leverage is calculated honestly
Hi David! Maybe it helps to start off with the DuPont equation, and then "zoom in" to financial leverage afterward: th-cam.com/video/bhbDDSohJ84/w-d-xo.html
@@TheFinanceStoryteller thank you, will check out the link
What does it mean by equity?
Equity is a term used in accounting, in real estate and home-ownership, in investing, as well as in startup financing and valuation. In accounting, equity is a term that you will find on the balance sheet: the book value of the shareholder capital. See my video "What is equity": th-cam.com/video/Q1z395u60xU/w-d-xo.html
The Finance Storyteller thank you very much for your comprehensive explanation!
@@tiffanyytn You're welcome! Happy to help. :-)
But do banks really provide these type of loans!?
Hello Hussain! Sadly, they do (to a certain extent). More painful is that trading platforms offer this to inexperienced investors, leading to blowups on the personal level.
@@TheFinanceStorytellerIn the real estate scenario.....I can just borrow money from the bank....buy a house with it and rent it....pay the debt from the rent.......and within 7 to 10 years the house is mine......what is the problem here!?
@@hussainnoordeen7849 Under normal conditions, no problem. When real estate prices drop, big problem. See the 2007-2009 financial crisis.
Please explain it as if I was 5yo
In order to get there, it might be good to first watch one or more videos on the DuPont ROE equation (including examples of how to calculate it based on the numbers of real world companies), and only once that is fully clear dive into the specifics of financial leverage (which is an element of it): th-cam.com/video/bhbDDSohJ84/w-d-xo.html
Is this why Manchester United are so heavily in debt and the Glazers are making so much money out of the club?
Sorry, I don't know the answer to that... don't follow football at all.
It could be explained much easier
Go for it! Look forward to seeing your video on the topic. 🙂
My Brain Hurts
Then either watch some Monty Python, or get away from your screen for a while.
@@TheFinanceStoryteller Nah I think your just too smart for me.
🙏🤝♟️
Thanks a lot!!!
You're welcome!