A company needs financial capital in order to operate its business.

For most
companies, financial capital is raised by issuing debt securities and/or by
selling common stock. The amount of debt and equity that makes up a
companys capital structure has many risk and return implications. Therefore,
corporate management has an obligation to use a thorough and prudent process
for establishing a companys target capital structure. The capital structure is how
a firm finances its operations and growth by using different sources of funds.

Empirical Use of Financial Leverage

Financial leverage is defined as the extent to which fixed-income

securities and preferred stock are used in a companys capital structure.
Financial leverage has value due to the interest tax shield that is afforded by the
U.S. corporate income tax law. The use of financial leverage also has value
when the assets that are purchased with the debt capital earn more than the cost
of the debt that was used to finance them. Under both of these circumstances,
the use of financial leverage increases the companys profits. With that said, if
the company does not have sufficient taxable income to shield, or if its operating
profits are below a critical value, financial leverage will reduce equity value and
thus reduce the value of the company.

Given the importance of a companys capital structure, the first step in the capital
decision making process is for the management of a company to decide how
much external capital it will need to raise to operate its business. Once this
amount is determined, management needs to examine the financial markets to
determine the terms in which the company can raise capital. This step is crucial
to the process, because the market environment may curtail the ability of the
company to issue debt securities or common stock at an attractive level or cost.
With that said, once these questions have been answered, the management of a
company can design the appropriate capital structure policy, and construct a
package of financial instruments that need to be sold to investors. By following
this systematic process, managements financing decision should be
implemented according to its long-run strategic plan, and the manner in which it
wants to grow the company over time.

The use of financial leverage varies greatly by industry and by business sector.
There are many industry sectors in which companies operate with a high degree
of financial leverage. Retail stores, airlines, grocery stores, utility companies, and
banking institutions are classic examples. Unfortunately, the excessive use of
financial leverage by many companies in these sectors has played a paramount
role in forcing a lot of them to file for Chapter 11 bankruptcy. Examples include
R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic & Pacific Tea Co
(A&P) (2010), and Midwest Generation (2012). Moreover, excessive use of
financial leverage was the primary culprit that led to the U.S. financial
crisis between 2007 and 2009. The demise of Lehman Brothers (2008) and a
host of other highly levered financial institutions are prime examples of the
negative ramifications that are associated with the use of highly levered capital
structures.

Overview of the Modigliani and Miller Theorem on Corporate Capital

Structure

The study of a companys optimal capital structure dates back to 1958

when Franco Modigliani and Merton Miller published their Nobel Prize winning
work The Cost of Capital, Corporation Finance, and the Theory of Investment.
As an important premise of their work, Modigliani and Miller illustrated that under
conditions where corporate income taxes and distress costs are not present in
the business environment, the use of financial leverage has no effect on the
value of the company. This view, known as the Irrelevance Proposition theorem,
is one of the most important pieces of academic theory that has ever been
published.

Unfortunately, the Irrelevance Theorem, like most Nobel Prize winning works in
economics, require a number of impractical assumptions that need to be
accepted to apply the theory in a real world environment. In recognition of this
problem, Modigliani and Miller expanded their Irrelevance Proposition theorem to
include the impact of corporate income taxes, and the potential impact of distress
cost, for purposes of determining the optimal capital structure for a company.
Their revised work, universally known as the Trade-off Theory of capital
structure, makes the case that a companys optimal capital structure should be
the prudent balance between the tax benefits that are associated with the use of
debt capital, and the costs associated with the potential for bankruptcy for the
company. Today, the premise of the Trade-off Theory is the foundation that
corporate management should be using to determine the optimal capital structure
for a company.

Impact of Financial Leverage on Performance

Perhaps the best way to illustrate the positive impact of financial leverage on a
companys financial performance is by providing a simple example. The Return
on Equity (ROE) is a popular fundamental used in measuring the profitability of a
business as it compares the profit that a company generates in a fiscal year with
the money shareholders have invested. After all, the goal of every business is
to maximize shareholder wealth, and the ROE is the metric of return on
shareholder's investment.
In the table below, an income statement for Company ABC has been generated
assuming a capital structure that consists of 100% equity capital. Capital raised
was $50 million dollars. Since only equity was issued to raise this amount, total
value of equity is also $50 million. Under this type of structure, the companys
ROE is projected to fall between the range of 15.6 and 23.4%, depending on the
level of the companys pre-tax earnings.

In comparison, when Company ABCs capital structure is re-engineered to

consist of 50% debt capital and 50% equity capital, the companys ROE
increases dramatically to a range that falls between 27.3 and 42.9%.

As you can see from the table below, financial leverage can be used to make the
performance of a company look dramatically better than what can be achieved by
solely relying on the use of equity capital financing.
Since the management of most companies relies heavily on ROE to measure
performance, it is vital to understand the components of ROE to better
understand what the metric conveys.

A popular methodology for calculating ROE is the utilization of the DuPont Model.
In its most simplistic form, the DuPont Model establishes a quantitative
relationship between net income and equity, where a higher multiple reflects
stronger performance. However, the DuPont Model also expands upon the
general ROE calculation to include three of its component parts. These parts
include the companys profit margin , its asset turnover, and its equity multiplier.
Accordingly, this expanded DuPont formula for ROE is as follows:

Based on this equation, the DuPont Model illustrates that a companys ROE can
only be improved by increasing the companys profitability, by increasing its
operating efficiency, or by increasing its financial leverage.

Measurement of Financial Leverage Risk

Corporate management tends to measure financial leverage by using short-term

solvency ratios. Like the name implies, these ratios are used to measure the
ability of the company to meet its short-term obligations. Two of the most utilized
short-term solvency ratios are the current ratio and acid-test ratio. Both of these
ratios compare the companys current assets to its current liabilities. However,
while the current ratio provides an aggregated risk metric, the acid-test ratio
provides a better assessment of the composition of the companys current assets
for purposes of meeting its current liability obligations since it excludes inventory
from current assets.

Capitalization ratios are also used to measure financial leverage. While there are
many capitalization ratios that are used in the industry, two of the most
popular metrics are the long-term-debt-to-capitalization ratio and the total-debt-
to-capitalization ratio. The use of these ratios is also very important for
measuring financial leverage. However, these ratios can be easily distorted if
management leases the companys assets without capitalizing the assets'
value on the companys balance sheet . Moreover, in a market environment
where short-term lending rates are low, management may elect to use short-term
debt to fund both its short- and long-term capital needs. Therefore, short-term
capitalization metrics also need to be used to conduct a thorough risk analysis.

Coverage ratios are also used to measure financial leverage. The interest
coverage ratio, also known as the times-interest-earned ratio, is perhaps the
most well-known risk metric. The interest coverage ratio is very important
because it provides an indication of a companys ability to have enough pre-
tax operating income to cover the cost of its financial burden. The funds-from-
operations-to-total-debt ratio, and the free-operating-cash-flow-to-total-debt ratio
are also important risk metrics that are used by corporate management.

Factors Considered in the Capital Structure Decision-Making Process

There are many quantitative and qualitative factors that need to be taken into
account when establishing the companys capital structure. First, from the
standpoint of sales, a company that exhibits high and relatively stable sales
activity is in a better position to utilize financial leverage, as compared to a
company that has lower and more volatile sales.

Second, in terms of business risk, a company with less operating leverage tends
to be able to take on more financial leverage than a company with a high degree
of operating leverage.

Third, in terms of growth, faster growing companies are likely to rely more heavily
on the use of financial leverage, because these types of companies tend to need
more capital at their disposal than their slow growth counterparts.

Fourth, from the standpoint of taxes, a company that is in a higher tax

bracket tends to utilize more debt to take advantage of the interest tax shield
benefits.

Fifth, a company that is less profitable tends to use more financial leverage,
because a less profitable company is typically not in a strong enough position to
finance its business operations from internally generated funds.

The capital structure decision can also be addressed by looking at a host of

internal and external factors. First, from the standpoint of management,
companies that are run by aggressive leaders tend to use more financial
leverage. In this respect, their purpose for using financial leverage is not only to
increase the performance of the company, but to also help ensure their control of
the company.

Second, when times are good, capital can be raised by issuing either stocks or
bonds. However, when times are bad, suppliers of capital typically prefer a
secured position, which in turn puts more emphasis on the use of debt capital.
With this in mind, management tends to structure the capital makeup of the
company in a manner that will provide flexibility in raising future capital in an
ever-changing market environment.

The Bottom Line

In essence, corporate management utilizes financial leverage primarily to

increase the companys earnings per share and to increase its return-on-equity.
However, with these advantages come increased earnings variability and the
potential for an increase in the cost of financial distress, perhaps even
bankruptcy. With this in mind, the management of a company should take into
account the business risk of the company, the companys tax position, the
financial flexibility of the companys capital structure, and the companys degree
of managerial aggressiveness when determining the optimal capital structure.

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corporate-capital-structure.asp
Leverage (finance)
In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is any
technique involving the use of borrowed funds in the purchase of an asset, with the expectation that
the after tax income from the asset and asset price appreciation will exceed the borrowing cost.
Normally, the finance provider would set a limit on how much risk it is prepared to take and will set a
limit on how much leverage it will permit, and would require the acquired asset to be provided as
collateral security for the loan. For example, for a residential property the finance provider may lend
up to, say, 80% of the property's market value, for a commercial property it may be 70%, while on
shares it may lend up to, say, 60% or none at all on some shares.
Leveraging enables gains and losses to be multiplied.[1] On the other hand, there is a risk that
leveraging will result in a loss ie., it actually turns out that financing costs exceed the income from
the asset, or because the value of the asset has fallen.

Sources[edit]
Leverage can arise in a number of situations, such as:

individuals leverage their savings when buying a home by financing a portion of the purchase
price with mortgage debt.
individuals leverage their exposure to financial investments by borrowing from their broker.
securities like options and futures contracts are bets between parties where the principal is
implicitly borrowed/lent at very short T-bill rates.[2]
equity owners of businesses leverage their investment by having the business borrow a portion
of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are
shared among a smaller base and are proportionately larger as a result.[3]
businesses leverage their operations by using fixed cost inputs when revenues are expected to
be variable. An increase in revenue will result in a larger increase in operating income.[4][5]
hedge funds may leverage their assets by financing a portion of their portfolios with the cash
proceeds from the short sale of other positions.

Risk[edit]
While leverage magnifies profits when the returns from the asset more than offset the costs of
borrowing, leverage may also magnify losses. A corporation that borrows too much money might
face bankruptcy or default during a business downturn, while a less-leveraged corporation might
survive. An investor who buys a stock on 50% margin will lose 40% if the stock declines 20%.[6]
Risk may be attributed to a loss in value of collateral assets. Brokers may require the addition of
funds when the value of securities hold declines. Banks may fail to renew mortgages when the value
of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to
maintain the ongoing borrowing costs, loans may be called.
This may happen exactly when there is little market liquidity and sales by others are depressing
prices. It means that as things get bad, leverage goes up, multiplying losses as things continue to go
down. This can lead to rapid ruin, even if the underlying asset value decline is mild or
temporary.[6] The risk can be mitigated by negotiating the terms of leverage, by maintaining unused
room for additional borrowing, and by leveraging only liquid assets.[7]
On the other hand, the extreme level of leverage afforded in forex trading presents relatively low risk
per unit due to its relative stability when compared with other markets. Compared with other trading
markets, forex traders must trade a much higher volume of units in order to make any considerable
profit. For example, many brokers offer 100:1 leverage for investors, meaning that someone bringing
$1,000 can control $100,000 while taking responsibility for any losses or gains their investments
incur. This intense level of leverage presents equal parts risk and reward.
There is an implicit assumption in that account, however, which is that the underlying levered asset
is the same as the unlevered one. If a company borrows money to modernize, or add to its product
line, or expand internationally, the additional diversification might more than offset the additional risk
from leverage.[6] Or if an investor uses a fraction of his or her portfolio to margin stock index futures
and puts the rest in a money market fund, he or she might have the same volatility and expected
return as an investor in an unlevered equity index fund, with a limited downside.[7] Or if both long and
short positions are held by a pairs-trading stock strategy the matching and off-setting economic
leverage may lower overall risk levels.
So while adding leverage to a given asset always adds risk, it is not the case that a levered company
or investment is always riskier than an unlevered one. In fact, many highly levered hedge funds have
less return volatility than unlevered bond funds,[7] and public utilitieswith lots of debt are usually less
risky stocks than unlevered technology companies.[6]

Effect on rates of return[edit]

Here is an example showing the calculation of the expected return resulting from leverage. There is
a short-form calculation and a long-form that is more intuitive.[8] Given:
The following example is for an investor who seeks to purchase shares of a well performing asset
(+5% expected growth). The investor seeks to increase the total amount purchased by leveraging
the purchase with borrowed money. A lender and the investor establish the following terms: the
lender will permit the investor to leverage the purchase by agreeing to a loan that is equal to eight
times the equity investment; for every 1 dollar invested (equity), the lender will lend 8 (leverage). The
cost of the loan is 4% of the loan amount. +5% asset return
4% leverage cost
8:1 leverage ratio
LONG-FORM math
The gross total amount of asset performance following the leveraged purchase is equal to the total
quantity of asset purchased multiplied by the Asset Return. In this case, the quantity of asset
purchased is equal to 9 (8 from loan funds + 1 from equity funds) and the Asset Return is +5%. So
the gross total profit from the leveraged asset purchase = 9 times +5% = +45% gross total profit from
leveraged asset purchase. To arrive at net profit, the leverage cost is subtracted from the gross total
costs. The cost of the loan is 4% of the loan amount, and the loan is 8 per dollar of equity or 8 times
4% = 32% cost. So the sum of total profit and total cost is +45% profit minus 32% cost = 13% net
profit from the leveraged purchase per dollar of equity investment = expected leverage return on
equity investment.
SHORT-FORM math
Asset Leverage Differential = sum of Asset's Return and the Cost of Leverage Debt = +5% 4%
= +1% Rate Leveraged Asset Return
Leveraged Debt to Equity Investment Ratio = 8 divided by 1 = 8 Leverage Factor
Multiply first two lines = Rate of Leveraged Asset Return x Leverage Factor = + 1% 8 = +8%
Return on Leverage
Add Return on Asset's = 5% Equals Rate of Leveraged Asset Return = sum of Asset Return and
Leverage 8% + 5% = 13%
Measuring[edit]
A good deal of confusion arises in discussions among people who use different definitions of
leverage. The term is used differently in investments and corporate finance, and has multiple
definitions in each field.[9]

Investments[edit]
Accounting leverage is total assets divided by the total assets minus
total liabilities.[10] Notional leverage is total notional amount of assets plus total notional amount of
liabilities divided by equity.[1] Economic leverage is volatility of equity divided by volatility of an
unlevered investment in the same assets. To understand the differences, consider the following
positions, all funded with $100 of cash equity:[6]

Buy $100 of crude oil with money out of pocket. Assets are $100 ($100 of oil), there are no
liabilities, and assets minus liabilities equals owners' equity. Accounting leverage is 1 to 1. The
notional amount is $100 ($100 of oil), there are no liabilities, and there is $100 of equity, so
notional leverage is 1 to 1. The volatility of the equity is equal to the volatility of oil, since oil is
the only asset and you own the same amount as your equity, so economic leverage is 1 to 1.
Borrow $100 and buy $200 of crude oil. Assets are $200, liabilities are $100 so accounting
leverage is 2 to 1. The notional amount is $200 and equity is $100, so notional leverage is 2 to
1. The volatility of the position is twice the volatility of an unlevered position in the same assets,
so economic leverage is 2 to 1.
Buy $100 of crude oil, borrow $100 worth of gasoline, and sell the gasoline for $100. The seller
now has $100 cash and $100 of crude oil, and owes $100 worth of gasoline. Your assets are
$200, and liabilities are $100, so accounting leverage is 2 to 1. You have $200 in notional assets
plus $100 in notional liabilities, with $100 of equity, so your notional leverage is 3 to 1. The
volatility of your position might be half the volatility of an unlevered investment in the same
assets, since the price of oil and the price of gasoline are positively correlated, so your economic
leverage might be 0.5 to 1.
Buy $100 of a 10-year fixed-rate treasury bond, and enter into a fixed-for-floating 10-
year interest rate swap to convert the payments to floating rate. The derivative is off-balance
sheet, so it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1. The
notional amount of the swap does count for notional leverage, so notional leverage is 2 to 1. The
swap removes most of the economic risk of the treasury bond, so economic leverage is near
zero.
Abbreviations[edit]

EBIT means Earnings before interest and taxes.

DOL is Degree of Operating Leverage
DFL is Degree of Financial Leverage
DCL is Degree of Combined Leverage
ROE is Return on equity
ROA is Return on assets
Corporate finance[edit]
Accounting leverage has the same definition as in investments.[11] There are several
ways to define operating leverage, the most common.[12] is:

Financial leverage is usually defined[10][13] as:

For outsiders, it is hard to calculate operating leverage as fixed and variable

costs are usually not disclosed. In an attempt to estimate operating leverage,
one can use the percentage change in operating income for a one-percent
change in revenue.[14] The product of the two is called Total leverage,[15] and
estimates the percentage change in net income for a one-percent change in
revenue.[16]
There are several variants of each of these definitions,[17] and the financial
statements are usually adjusted before the values are computed.[10] Moreover,
there are industry-specific conventions that differ somewhat from the treatment
above.[18]

Bank regulation[edit]
After the 1980s, quantitative limits on bank leverage were rare. Banks in most
countries had a reserve requirement, a fraction of deposits that was required to
be held in liquid form, generally precious metals or government notes or
deposits. This does not limit leverage. A capital requirement is a fraction of
assets that is required to be funded in the form of equity or equity-like securities.
Although these two are often confused, they are in fact opposite. A reserve
requirement is a fraction of certain liabilities (from the right hand side of the
balance sheet) that must be held as a certain kind of asset (from the left hand
side of the balance sheet). A capital requirement is a fraction of assets (from the
left hand side of the balance sheet) that must be held as a certain kind of
liability or equity (from the right hand side of the balance sheet). Before the
1980s, regulators typically imposed judgmental capital requirements, a bank
was supposed to be "adequately capitalized," but these were not objective
rules.[19]
National regulators began imposing formal capital requirements in the 1980s,
and by 1988 most large multinational banks were held to the Basel I standard.
Basel I categorized assets into five risk buckets, and mandated minimum capital
requirements for each. This limits accounting leverage. If a bank is required to
hold 8% capital against an asset, that is the same as an accounting leverage
limit of 1/.08 or 12.5 to 1.[20]
While Basel I is generally credited with improving bank risk management it
suffered from two main defects. It did not require capital for all off-balance sheet
risks (there was a clumsy provisions for derivatives, but not for certain other off-
balance sheet exposures) and it encouraged banks to pick the riskiest assets in
each bucket (for example, the capital requirement was the same for all
corporate loans, whether to solid companies or ones near bankruptcy, and the
requirement for government loans was zero).[19]
Work on Basel II began in the early 1990s and it was implemented in stages
beginning in 2005. Basel II attempted to limit economic leverage rather than
accounting leverage. It required advanced banks to estimate the risk of their
positions and allocate capital accordingly. While this is much more rational in
theory, it is more subject to estimation error, both honest and
opportunitistic.[20] The poor performance of many banks during the financial
crisis of 20072009 led to calls to reimpose leverage limits, by which most
people meant accounting leverage limits, if they understood the distinction at all.
However, in view of the problems with Basel I, it seems likely that some hybrid
of accounting and notional leverage will be used, and the leverage limits will be
imposed in addition to, not instead of, Basel II economic leverage limits.[21]

Financial crisis of 20072009[edit]

The financial crisis of 20072009, like many previous financial crises, was
blamed in part on "excessive leverage".

Consumers in the United States and many other developed countries had
high levels of debt relative to their wages, and relative to the value of
collateral assets. When home prices fell, and debt interest rates reset
higher, and business laid off employees, borrowers could no longer afford
debt payments, and lenders could not recover their principal by selling
collateral.
Financial institutions were highly levered. Lehman Brothers, for example, in
its last annual financial statements, showed accounting leverage of 31.4
times ($691 billion in assets divided by $22 billion in stockholders
equity).[22] Bankruptcy examiner Anton R. Valukasdetermined that the true
accounting leverage was higher: it had been understated due to dubious
accounting treatments including the so-called repo 105 (allowed by Ernst &
Young).[23]
Banks' notional leverage was more than twice as high, due to off-balance
sheet transactions. At the end of 2007, Lehman had $738 billion of notional
derivatives in addition to the assets above, plus significant off-balance
sheet exposures to special purpose entities, structured investment
vehicles and conduits, plus various lending commitments, contractual
payments and contingent obligations.[22]
On the other hand, almost half of Lehmans balance sheet consisted of
closely offsetting positions and very-low-risk assets, such as regulatory
deposits. The company emphasized "net leverage", which excluded these
assets. On that basis, Lehman held $373 billion of "net assets" and a "net
leverage ratio" of 16.1.[22] This is not a standardized computation, but it
probably corresponds more closely to what most people think of when they
hear of a leverage ratio.[citation needed]

Use of language[edit]
Levering has come to be known as "leveraging", in financial communities; this
may have originally been a slang adaptation, since leverage was a noun.
However, modern dictionaries (such as Random House
Dictionary and Merriam-Webster's Dictionary of Law[24]) refer to its use as
a verb, as well.[25] It was first adopted for use as a verb in American English in
1957.[26]
References[edit]

1. ^ Jump up to:a b Brigham, Eugene F., Fundamentals of Financial Management (1995).

2. Jump up^ Mock, E. J., R. E. Schultz, R. G. Schultz, and D. H. Shuckett, Basic Financial Management
(1968).
3. Jump up^ Grunewald, Adolph E. and Erwin E. Nemmers, Basic Managerial Finance (1970).
4. Jump up^ Ghosh, Dilip K. and Robert G. Sherman (June 1993). "Leverage, Resource Allocation and
Growth". Journal of Business Finance & Accounting. pp. 575582.
5. Jump up^ Lang, Larry, Eli Ofek, and Rene M. Stulz (January 1996). "Leverage, Investment, and Firm
Growth". Journal of Financial Economics. pp. 329.
6. ^ Jump up to:a b c d e Bodie, Zvi, Alex Kane and Alan J. Marcus, Investments, McGraw-Hill/Irwin (June
18, 2008)
7. ^ Jump up to:a b c Chew, Lillian (July 1996). Managing Derivative Risks: The Use and Abuse of
Leverage. John Wiley & Sons.
8. Jump up^ Math for calculating leverage effects
9. Jump up^ Van Horne (1971). Financial Management and Policy.
10. ^ Jump up to:a b c Weston, J. Fred and Eugene F. Brigham, Managerial Finance (1969).
11. Jump up^ Weston, J. Fred and Eugene F. Brigham, Managerial Finance (2010).
12. Jump up^ Brigham, Eugene F., Fundamentals of Financial Management (1995)
13. Jump up^ "Financial Leverage". Retrieved 16 December 2012.
14. Jump up^ Damodaran (2011), Applied Corporate Finance, 3rd ed., pp. 132133>
15. Jump up^ Li, Rong-Jen and Glenn V. Henderson, Jr., "Combined Leverage and Stock Risk,"
Quarterly Journal of Business & Finance (Winter 1991), pp. 1839.
16. Jump up^ Huffman, Stephen P., "The Impact of Degrees of Operating and Financial Leverage on the
Systematic Risk of Common Stock: Another Look," Quarterly Journal of Business & Economics
(Winter 1989), pp. 83100.
17. Jump up^ Dugan, Michael T., Donald Minyard, and Keith A. Shriver, "A Re-examination of the
Operating Leverage-Financial Leverage Tradeoff," Quarterly Review of Economics & Finance (Fall
1994), pp. 327334.
18. Jump up^ Darrat, Ali F.d and Tarun K. Mukherjee, "Inter-Industry Differences and the Impact of
Operating and Financial Leverages on Equity Risk," Review of Financial Economics (Spring 1995),
pp. 141155.
19. ^ Jump up to:a b Ong, Michael K., The Basel Handbook: A Guide for Financial Practitioners, Risk
Books (December 2003)
20. ^ Jump up to:a b Saita, Francesco, Value at Risk and Bank Capital Management: Risk Adjusted
Performances, Capital Management and Capital Allocation Decision Making, Academic Press
(February 3, 2007)
21. Jump up^ Tarullo, Daniel K., Banking on Basel: The Future of International Financial
Regulation, Peterson Institute for International Economics (September 30, 2008)
22. ^ Jump up to:a b c Lehman Brothers Holdings Inc Annual Report for year ended November 30,
2007 https://www.sec.gov/Archives/edgar/data/806085/000110465908005476/a08-
3530_110k.htm#Item6_SelectedFinancialData_003911.
23. Jump up^ Report of Anton R. Valukas, Examiner, to the United States Bankruptcy Court, Southern
District of New York, Chapter 11 Case No. 08-13555 (JMP).
24. Jump up^ Merrian-Webster's Dictionary of Law. Merriam-Webster. June 2011. ISBN 978-
0877797197.
25. Jump up^ "leverage." Merriam-Webster's Dictionary of Law. Merriam-Webster, Inc. 7 June
2011. Dictionary.com
26. Jump up^ "leverage." Online Etymology Dictionary. Douglas Harper, Historian. 7 June
2011. Dictionary.com
What is a 'Leverage Ratio'
Companies rely on a mixture of owners' equity and debt to finance their
operations. A leverage ratio is any one of several financial measurements that
look at how much capital comes in the form of debt (loans), or assesses the
ability of a company to meet financial obligations.

BREAKING DOWN 'Leverage Ratio'

Too much debt can be dangerous for a company and its investors. Uncontrolled
debt levels can lead to credit downgrades or worse. On the other hand, too few
debts can also raise questions. If a company's operations can generate a higher
rate of return than the interest rate on its loans, then the debt is helping to fuel
growth in profits. A reluctance or inability to borrow may be a sign that operating
margins are simply too tight.

There are several different specific ratios that may be categorized as a leverage
ratio, but the main factors considered are debt, equity, assets and interest
expenses.

A leverage ratio may also refer to one used to measure a company's mix of
operating costs, giving an idea of how changes in output will affect operating
income. Fixed and variable costs are the two types of operating costs; depending
on the company and the industry, the mix will differ.

Finally, the consumer leverage ratio refers to the level of consumer debt as
compared to disposable income and is used in economic analysis and by
policymakers

Leverage Ratios for Evaluating Solvency and Capital

Structure
The most well known financial leverage ratio is the debt-to-equity ratio. It is
expressed as:

Total Debt / Total Equity

For example, if a company has $10M in debt and $20M in equity, it has a debt-to-
equity ratio of 0.50 = ($10M/$20M). A high debt/equity ratio generally indicates
that a company has been aggressive in financing its growth with debt. This can
result in volatile earnings as a result of the additional interest expense, and if it is
very high, it may increase the chances of a default or bankruptcy. Typically a
debt to equity ratio greater than 2.0 indicates a risky scenario for the investor,
however this yardstick can vary by industry. Businesses that require large capital
expenditures (CapEx) may need to secure more loans than other companies. It's
a good idea to measure a firm's leverage ratios against past performance and its
competitors' performance to better understand the data.

See which online broker offers Leverage Ratio Analysis by visiting

Investopedia's brokerage reviewcenter.

The financial leverage ratio is similar, but replaces debt with assets in the
numerator:

Avg. Total Assets/ Avg. Total Equity

The financial leverage ratio is sometimes referred to as the equity multiplier. For
example, a company has assets valued at $2 billion and stockholder equity of $1
billion. The equity multiplier value would be 2.0 ($2 billion / $1 billion), meaning
that one half of a companys assets are financed by equity. The balance must be
financed by debt.

The financial leverage ratio is a component of the decomposed DuPont

analysis for calculating return on equity (ROE):

ROE = Net Profit Margin x Asset Turnover x Financial

Leverage Ratio

An indicator that measures the total amount of debt in a companys capital

structure is the debt-to-capitalization ratio, which measures a companys financial
leverage. It is calculated as:

Long-term Debt to Capitalization Ratio = Long-term Debt / (Long-Term Debt +

minority interest + equity)

In this ratio, operating leases are capitalized and equity includes both common
and preferred shares.

Total Debt to Capitalization Ratio = (current liabilities + Long-Term Debt) /

(current liabilities + Long-Term Debt + minority interest + equity)

Degree of Financial Leverage

Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a
companys earnings per share (EPS) to fluctuations in its operating income, as a
result of changes in its capital structure. It measures the percentage change in
EPS for a unit change in earnings before interest and taxes(EBIT), and is
represented as:
DFL can also be represented by the equation below:

This ratio indicates that the higher the degree of financial leverage, the more
volatile earnings will be. Since interest is usually a fixed expense, leverage
magnifies returns and EPS. This is good when operating income is rising, but it
can be a problem when operating income is under pressure.

Consumer Leverage Ratio

The consumer leverage ratio is used to quantify the amount of debt the average
American consumer has, relative to their disposable income.

Some economists have stated that the rapid increase in consumer debt
levels has been a main factor for corporate earnings growth over the past few
decades. Others have blamed the high level of consumer debt as a major cause
of the great recession.

Consumer Leverage Ratio = Total household debt/ Disposable personal income

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How Much Leverage Is Right
for You in Forex Trades

Understanding how to trade foreign currencies requires detailed knowledge about the economies
and political situations of individual countries, global macroeconomics and the impact of
volatility on specific markets. But the truth is, it isnt usually economics or global finance that
trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is often
at the root of trading losses.

Data disclosed by the largest foreign-exchange brokerages as part of the Dodd-Frank Wall Street
Reform and Consumer Protection Act indicates that a majority of retail forex customers lose
money. The misuse of leverage is often viewed as the reason for these losses. This article
explains the risks of high leverage in the forex markets, outlines ways to offset risky leverage
levels and educates readers on ways to pick the right level of exposure for their comfort. (For an
introduction to currency trading, read Forex Tutorial: The Forex Market.)
The Risks of High Leverage
Leverage is a process in which an investor borrows money in order to invest in or purchase
something. In forex trading, capital is typically acquired from a broker. While forex traders are
able to borrow significant amounts of capital on initial margin requirements, they can gain even
more from successful trades. (For more read How does leverage work in the forex market?)

In the past, many brokers were able to offer significant leverage ratios as high as 400:1. This
means, that with only a $250 deposit, a trader could control roughly $100,000 in currency on the
global forex markets. However, financial regulations in 2010 limited the leverage ratio that
brokers could offer to U.S.-based traders to 50:1 (still a rather large amount). This means that
with the same $250 deposit, traders can control $12,500 in currency.

So, should a new currency trader select a low level of leverage such as 5:1 or roll the dice and
ratchet the ratio up to 50:1? Before answering, its important to take a look at examples showing
the amount of money that can be gained or lost with various levels of leverage.

Example Using Maximum Leverage

Imagine Trader A has an account with $10,000 cash. He decides to use the 50:1 leverage, which
means that he can trade up to $500,000. In the world of forex, this represents five standard lots.
There are three basic trade sizes in forex: a standard lot (100,000 units of quote currency), a mini
lot (10,000 units of base currency), and a micro lot (1,000 units of quote currency). Movements
are measured in pips. Each one-pip movement in a standard lot is a 10 unit change.

Because the trader purchased five standard lots, each one-pip movement will cost $50 ($10
change/standard lot X 5 standard lots). If the trade goes against the investor by 50 pips, the
investor would lose 50 pips X $50 = $2,500. This is 25% of the total $10,000 trading account.

Example Using Less Leverage

Lets move on to Trader B. Instead of maxing out leverage at 50:1, she chooses a more
conservative leverage of 5:1. If Trader B has an account with $10,000 cash, she will be able to
trade $50,000 of currency. Each mini-lot would cost $10,000. In a mini lot, each pip is a $1
change. Since Trader B has 5 mini lots, each pip is a $5 change.

Should the investment fall that same amount, by 50 pips, then the trader would lose 50 pips X $5
= $250. This is just 2.5% of the total position. (For a detailed explanation of how leverage works,
read Forex Leverage: A Double-Edged Sword.)

How to Pick the Right Leverage Level

There are widely accepted rules that investors should review before selecting a leverage level.
The easiest three rules of leverage are:

1. Maintain low levels of leverage.

2. Use trailing stops to reduce downside and protect capital.
 3. Limit capital to 1% to 2% of total trading capital on each position taken.

Forex traders should choose the level of leverage that makes them most comfortable. If you are
conservative and dont like taking many risks, or if youre still learning how to trade currencies,
a lower level of leverage like 5:1 or 10:1 might be more appropriate. (For more read The Basics
of Forex Leveraging.)

Trailing or limit stops provide investors with a reliable way to reduce their losses when a trade
goes in the wrong direction. By using limit stops, investors can ensure that they can continue to
learn how to trade currencies but limit potential losses if a trade fails. These stops are also
important because they help reduce the emotion of trading and allow individuals to pull
themselves away from their trading desks without emotion. (For more on protective stops, read
The Stop-Loss Order - Make Sure You Use It.)

The Bottom Line

Selecting the right forex leverage level depends on a traders experience, risk tolerance and
comfort when operating in the global currency markets. New traders should familiarize
themselves with the terminology and remain conservative as they learn how to trade and build
experience. Using trailing stops, keeping positions small and limiting the amount of capital for
each position is a good start to learning the proper way to manage leverage.