Ever wondered what was behind that dreaded term, financial leverage? Here’s a quick write-up how I see it work:
RoE=RoA + (RoA-i)*(Debt/Equity)
A bit of explanation to this mumbo jumbo:
- Return on Equity is the one we’re after: this is what an investor, stock holder or a manager wants to maximise. Basically the profit divided by equity.
- RoA is return on assets. Simply the operational profit divided by the total assets.
- i is the average interest paid on the financial debts. Therefore (RoA – i) is what we call the ‘excess return’, normally the positive difference between what the return of your operation is and the cost of your loans to finance that operation
- Debt-to-equity ratio: as the name says, the ratio of debt to equity. The higher the debt, the higher the ratio.
‘Financial leverage’ is the second part in the formula above, the part in bold. Assuming your operation is giving an excess return, that return gets multiplied by the debt to equity ratio and can thereby increase the original RoA significantly!
In this formula, it is easy to see how things can quickly go wrong: should the return on assets fall below the interest on the debt, this negative effect would be reinforced by the amount of debt vs equity, leading to a RoE which is far below RoA. The operation could be profitable (RoA>0) but through its financing, still give no return to its stockholders.
More on this to follow, I am having a major refreshment on finance management in my MBA course! Let me know what more you want me to update you guys on!