Course 207: Leverage
What Financial Leverage Is
In this course
1 Introduction
2 Leverage in Stock Investing
3 What Financial Leverage Is
4 How Much Leverage Is Too Much?

Leverage is important in evaluating a business, too. Businesses have to decide how leveraged they want to be, and just as in the securities markets, increased leverage increases potential profitability and potential risk. The most common measure of leverage for publicly traded companies is financial leverage, equal to assets divided by equity. Financial leverage is a concept that anyone with a home mortgage can relate to. A homebuyer who puts $5,000 down on a $100,000 house has a financial-leverage ratio of 20. For every dollar in equity, the buyer has $20 in assets. The same holds true for companies. In 1999, entertainment conglomerate Walt Disney DIS had a financial-leverage ratio of 2.1, meaning that for every dollar in equity, the firm had $2.10 in total assets. (It borrowed the other $1.10.) A financial-leverage ratio of 2.1 is fairly conservative. It's when we see ratios of 4, 5, or more that companies start to get risky. Just like a homebuyer with an oversized mortgage, a company with lots of debt will have steep interest payments. If it can't meet those payments, it will go bankrupt. Such indebted outfits are vulnerable to recessions and rising interest rates, since both can make it tougher to meet interest payments. Not surprisingly, some of the most highly leveraged companies tend to be distressed firms, which are typically on the brink of bankruptcy and swimming in debt. Such concerns often have the worst of both worlds: a risky business and a high financial-leverage ratio. For example, Trans World Airlines TWA boasts a financial-leverage ratio of more than 10, a frightening figure for a company in a cyclical industry.

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