Calculate Financial Leverage

In the previous article “Debt Equity Ratio and Debt Ratio”, we discussed the relationships between debt-to-equity ratio and debt ratio and showed the formula to derive either one from the other. In this article, we are going to discuss the financial leverage and show the relationships between financial leverage and debt-to-equity ratio and use Starbucks as the example to show the calculation of financial leverage from its income and balance sheet statement

What is Financial Leverage

Financial leverage is a ratio to measure the multiply effect on the original return. Although there are many techniques to achieve this, the simplest way for a company to leverage its equity is by borrowing money. Let’s use Starbucks’ financial statement to explain how Starbucks multiplies its return by borrowing money. Here is the link to Starbucks’ income statement and balance sheet statement.

Calculate Financial Leverage from Financial Report

From its income statement, Starbucks has net income $1245.7M in 2011. Also from its balance sheet, Starbucks’ averaged Total Assets during 2010-2011 is $6873.15M ((7360.4+6385.9)/2). That gives Starbucks’ Return on Assets (ROA) 18.12% (1245.7/6873.15). However, from the investor’s point of view, the return is higher than 18.12%. When we purchase Starbucks’ stock, we become the stake holders of the company. That means we own a portion of the company’s equity depends on how many shares we have. In that sense, the actual return from the investor’s point of view should be calculated by using averaged Total Equity instead of averaged Total Assets.
From its balance sheet, Starbucks’ averaged Total Equity during 2010-2011 is $4029.8M ((4384.9+3674.7)/2). So the Return on Equity (ROE) for Starbucks is 30.91% ($1245.7M/$4029.8M), which is 1.71 x 18.12%. Because part of Starbucks’ assets is debts, it is able to generate higher return and we call the ratio 1.71 financial leverage

Calculate Financial Leverage from Debt Equity Ratio

From the above example, we can see that financial leverage = Return on Equity / Return on Assets, while Return on Equity = Net income / Averaged Total Equity, and Return on Assets = Net Income / Averaged Total Assets
=> Financial Leverage= Averaged Total Assets / Averaged Total Equity
= (Averaged Total Liabilities + Averaged Total Equity) / Averaged Total Equity
=> Financial Leverage = Debt-to-Equity Ratio + 1
Take Starbucks for example, it has averaged total liabilities $2843.35M ((2975.5+2711.2)/2) and averaged total equity $4029.8M. That gives us debt-to-equity ratio = 0.71. Because financial leverage ratio is also = Debt-to-Equity Ratio + 1, we get the same financial ratio 1.71

Commentary

The formula we derived above is convenient because Debt-to-Equity ratio is a common ratio that we can get. Simply add 1 to the debt-to-equity ratio then we can get the financial leverage ratio