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Feb 20, 2016 |
Financial Ratios,  |

The concept of financial leverage

The concept of financial leverage 

ROE = ROI + (ROI - Cost of Debt) x (Debt/Equity)
where: Cost of Debt = Financial charges/Debt capital   

The above formula reads as follows: the difference between the ROI and the cost of debt capital undergoes a multiplier effect by reason of the relationship (leverage) among debt capital and Equity. So if the ROI is greater than the interests on loans, the positive difference, expanded by the multiplier, is added to ROI, resulting into ROE being bigger than ROI. However, if the cost of debt exceeds the return of capital employed, we will have a negative value, which, once amplified by the multiplier, is subtracted from ROI and therefore leads to ROE being lower than ROI. It is also worth noting that, in the case the difference ROI-cost of capital has a positive value, the multiplier effect rewards those who dared more, i.e. businesses that have a relationship between means (loans) and Equity (Equity) leaning significantly towards indebtedness. Conversely, in the unfortunate event of a negative gap between ROI and cost of capital, the multiplier effect lessens the damage to companies that have behaved more prudently, i.e. that have limited the acquisition of loans from third parties to make more use of the funds of internal origin.