Financial Leverage Ratio Calculator is used for calculating the economic situation (capital) of an individual by taking into account and according to the analysis of the total assets, debt, and equity ratio. 

Financial Leverage Ratio Calculator will help you determine how many assets you own (income) and how many of them are obtained through other means of loans and investments, which increases debt ratio. Keeping track of the financial leverage ratio is very important for your business. It shows you if your business is going downhill and analyzes the potential risk of going bankrupt if you decide to take huge loans. Financial Leverage Ratio Calculator can be enormously helpful if used in finance to monitor the company’s leverage ratio.

We will show you how to use the Financial Leverage Ratio Calculator to calculate the total assets and equity ratio. We will also note whether the ratios we got from our examples are considered bad or good financial leverage ratios.

What is the financial leverage ratio

Okay, so I assume most of you are not familiar with the financial leverage ratio; thus, let me try to simplify it for you using non-legal terms. 

Let’s consider this scenario. A company wants to invest capital into a new building, workspace expansion, or a similar project but lacks enough resources. So they decide to use different means of credit and debt (cost coverage) to gather enough capital for the project. In finance, this is called the financial leverage ratio

Besides the financial leverage ratio, in finance, there is also a very important term – operating leverage ratio. The financial leverage ratio is very similar to the operating one, but primarily operating leverage ratio is used to indicate how well a company uses fixed costs to generate more income.

Debt, equity and return on investment (ROI)

The whole idea behind using capital from a bank’s credit or investors for a particular investment project is to have a higher return on investment, which will reduce the debt. Thus, the company profits from it at the end of the day. However, based on the analysis, you can never predict if the higher leverage ratio will benefit you and your business. But, you need to be aware that the more debt you take (higher financial leverage ratio and risk), the higher chances are to go bankrupt and lose everything. Thus, there has to be a balance, and you should never go too risky in it.

Investors never give loans to companies in massive debt and those with low equity. For example, suppose your company looks for investors to invest funds in your projects. In that case, the first thing they do is check your company in terms of eligibility for the loan and see if you can repay the loans due to a positive return on investment (ROI). Eligibility largely depends on equity ratio and debt status.

On the other hand, suppose you cannot pay interest on the debt, the capital you lent. In that case, investors will never see you as a potentially profitable company in which they can safely invest their funds.

Companies with low debt equity, capital, people label as companies with high leverage ratios. However, analysis tells that owners can reduce the high leverage ratio (debt) in finance by having higher debt equity or a high return on investment. An increase in the total equity ratio proportionally decreases debt ratio. Thus understanding these terms and their ratios in finance and business is crucial.

Financial leverage ratio formula

So, we have clarified what the financial leverage ratio is in a nutshell. But how do we get to the point where we know what financial leverage of your company is. There is a unique formula, the financial leverage ratio formula, that is used for it.

Even though you possibly can think of how useless or inefficient the formulas are, in general, the use of the financial leverage ratio formula will give a broad overview of the company’s financial status to its owners. The calculation result is not necessarily something you blindly follow, but rather statistics from which you can benefit. It helps you improve your business’s financial position (lower debt ratio).

How to calculate the financial leverage ratio

Well, just if we look at its name, we could figure out how the formula looks like. However, first, it’s essential to explain what current (short-term) & non-current assets (long-term) are. 

An asset in finance is something that a company owns and is of economic value. You can convert it into cash, and it is an investment from which a company can profit. There are two types of assets: current and non-current assets.

A current asset is an investment from which an individual can profit in the short term, within a year. Whereas the latter are some long-term plans and acquisitions, and we only can predict their final value after one accounting year, at least. 

Financial Leverage Ratio = \frac{Total Assets}{Total Equity Ratio}

The formula indicates what’s the present financial situation of the company. We do it by taking the total amount of assets the company has, and we divide that number by the amount of the total debt equity (the amount of capital we are left with when we pay all the costs and debts). Later, we will show you how easy it can be to use the formula and measure it quickly using the Financial Leverage Ratio Calculator.

Financial leverage ratio examples

We all love examples. Well, let me give you one to make the whole idea of financial leverage clear to you. I believe that one example of financial leverage is not enough. So I will provide you with at least two scenarios. We will go through them and use the formula to calculate the financial leverage ratio.

Financial leverage ratio scenario #1

Let’s assume there is a firm A and the owner decides to expand the company building one day. He also wants to invest in its surroundings, but this is a long-term plan. Expansion of the building equals $100,000, which is a current (short-term) asset. The long-term investments are about $2,000,000, for example. 

After paying all the debts and loans, the company’s shareholder’s equity is $1,000,000. We get this number from the formula by subtracting the total assets from the total liability (debt ratio). Now, you might wonder, “what is the financial leverage ratio in this scenario, and how can we measure it?”.

Financial Leverage Ratio = \frac{2,100,000}{1,000,000} = 2,10

We can calculate the formula by dividing the total assets ($2,100,000) by the shareholder’s equity ($1,000,000). So if we do look at the formula’s result, you will get the financial leverage ratio of 2,10, which is not so high (quite bearable). It’s perfectly normal for companies to be in debt, but you should carefully monitor debt. Too high debt can ruin your business instantly.

Financial leverage ratio scenario #2

Let’s pretend you have a friend called John, and he’s saved a lot of cash through the years to buy land and build a huge house for his family. However, John has only $50,000 current assets (convertible into cash within a year). In contrast, he expects to have $500,000 of non-current assets. So the total assets equal $550,000 in cash. However, John had to lend some money ($400,000) from the bank to gather enough money for his plan. The financial leverage ratio of John’s scenario is quite high and risky because his debt is excessive, and the total equity ratio is so low.

Financial Leverage Ratio = \frac{550,000}{150,000} = 3,66

John’s debt equity is very low ($150,000), and he has lent a lot of money (high debt), so he needs to be careful and find ways to return the loaned money to the bank.

FAQ

What is a good financial leverage ratio?

There is no universal number that we can surely take as a boundary between a good and a bad financial leverage ratio. However, the ratio should be ideally around 1. The ratio of 1 signifies that you have a pretty good total equity and a low debt in this scenario. As a result, you have a more increased chance of getting future funds from investors and banks with low debts.

Can financial leverage be negative?

The financial leverage ratio cannot be negative because the total assets will never be negative. Total equity also cannot be negative. So, if the total assets equal a negative number, the company is bankrupt because the balance is negative.

What is total equity?

We have already tackled this term through the article, but let me cover it here in a more detailed manner. Firstly, total equity shows us how much money we own and owe – total debt. If we take the number of total assets of the company and subtract it from the entire debt, we will get total equity. The higher the total equity is, the less the company is in debt. If the debt equity is lower, the company has a high liability (debt), the money they need to return to the lenders.

What is the difference between a current asset and a non-current asset?

A current asset is a company’s resource of economic value that can be converted into cash within one year (short term). These are resources that the company already owns and uses to cover the debt.
A non-current asset is a long-term investment whose final value cannot be determined within one year. This investment is something that a company can profit from in the next few years; however, the period is not explicitly defined.