FINANCIAL LEVERAGE

What do we mean about Financial Leverage ?

It is a relationship between the capital of third parties and the equity of a company.

Leverage is a real indicator of a financial nature, although it is used as a debt ratio for the calculation of the company's leverage. In fact, this ratio of assets expresses the degree of indebtedness of the company, which the corporates call as a degree of financial independence or debt quotient.

The "leverage" however allows us to identify those situations in which a given company has the convenience to borrow capital, that is, when the return on invested capital (ROI) is higher than the market rate. And, it will be higher the greater is the "leverage", which varies from a minimum zero value for the absence of third-party capital, to positive values when the company is in debt.

The term Leverage is used to understand and assess the financial structure of the company or the temporal relationship between sources of capital (permanent and current) and capital uses in fixed assets (long-term activities) or working activities (short-term activities).

In general, depending on the sector of the activity, a value of "leverage" between 1 and 3 can be considered symptomatic of a good balance of capital structure and consequently with a positive financial balance and therefore of good capital strength of the company, as the capital employed by the third parties will be between 1 and 3 (triple to that of equity) to that of the equity. However, if the value of "leverage" is over 3, the company could be considered undercapitalised (not enough capitalized) at least up to when this may create instability or addittional financial risk for stakeholders.

In other words, this indicator shows how the company's dependence on third-party capital makes the company undercapitalised.

When identifying the maximum tolerable value for an intervention (typically extraordinary operations of LBO "Leverage by out" or even MBO "Management by out"), the "leverage" allows to evaluate the company from an ex-ante and ex-post capital structure point of view and therefore of the financial riskiness of the transaction and therefore of the financial sustainability of the transaction. 

In conclusion, the leverage of a company can be measured with the ratio of debt capital (with or without interest charges) to equity (net worth or equity). However it can be optimized in consideration of other circumstances of the enterprise.

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