Compare Financial Leverage across Different Sector

In the previous article “Calculate Financial Leverage”, we explained what financial leverage is and its effect for the company’s return on equity. We also used Starbucks’ financial report as an example to show the way to calculate the financial leverage. Even though there is no guide line in terms of the amount of financial leverage the company should take, it seems that different business sectors would have different financial leverage due to the nature of the business. In this article, we are going to investigate this assumption and see if it is true.
 

Methodology

Sector Categorization

We categorize companies into nine sectors based on Yahoo Finance definition. The nine sectors are Basic Materials, Conglomerates, Consumer Goods, Financial, Healthcare, Industrial Goods, Services, Technology, and Utilities.
 

Company Selection

Among all tradable companies, we choose those that can be traded by options. The reason for that is because we would like to select companies that have certain liquidity. The company that can be traded by options means that they have certain liquidity. Currently there are 2253 companies that is option tradable.
 

Financial Leverage Calculation

For each selected company, we calculate its financial leverage simply by dividing its return on equity by its return on assets. After the financial leverage ratio for all companies are calculated, we choose the median of all companies belong to a certain sector to represent the financial leverage for that particular sector. Note the median is used instead of average to avoid the distortion due to long tail distribution
 

Result

Following table is the calculation result

Sector	Sample Number	Median FL
Technology	428	1.875
Basic Materials	322	1.935
Healthcare	204	1.98
Services	449	2
Industrial Goods	183	2.03
Consumer Goods	209	2.13
Conglomerates	9	2.37
Utilities	77	2.6
Financial	372	5.475

There are several observations we can make from this table:

1. Technology, Basic Materials, and Healthcare have financial leverage below 2
2. Services, Industrial Goods, Consumer Goods, and Utilities have financial leverage between 2 to 3
3. Comparing to the other eight sectors, Financial sector has much higher financial leverage (5.475)
Following is the financial leverage distribution comparison between Technology sector (lowest financial leverage) and financial sector (highest financial leverage)
 

Commentary

From the analysis above, there is a strong correlation between the amount of financial leverage companies take and the sector companies are at. It can be explained by the nature of business. In order for a technology company such as Apple to prosper, it requires the company to have sufficient cash all the time to support its research and development work. On the other hand, a company in financial sector such as Bank of America generates profit by using other people’s money (deposit). That explains why it has much higher financial leverage than other sectors