The term financial leverage index refers to a measure that allows the investor-analyst to understand the proportion of debt relative to equity being used to generate profits. The financial leverage index compares the company's return on equity to its return on assets.
Financial Leverage Index = Return on Equity / Return on Assets
Return on investment measures allow the investor-analyst to understand the company's ability to provide shareholders with an acceptable return on their investment. This is usually assessed by examining metrics such as net worth, returns on equity or assets, earnings, economic value added, and dividends. Return on investment metrics provide analysts with a way to determine a fair price to pay for a share of common stock. One of the ways to understand the amount of debt being used to generate profits relative to equity is by calculating a company's financial leverage index.
Investors in common stock are always concerned about the amount of leverage a company uses to generate profit since the correct use of leverage can increase an investor's return on equity, while the over-dependence on debt can lead to financial difficulties during an economic downturn. The financial leverage index provides investors with insights into the use of debt to grow profits. The metric compares the relative use of equity to generate profits (via return on equity) to the use of debt (return on assets). One alternative to this approach is to simply look at the company's balance sheet to see if there is a large amount of debt on the company's books.
A mutual fund manager would like to better understand the amount of leverage used by the software as a service (SaaS) industry. He asked his analytical team to evaluate a relatively large number of companies, of various sizes, in terms of capitalization. The team decided they would provide the fund manager with a quick view of the industry by calculating each company's financial leverage index. The fund manager could then evaluate each company relative to the average financial leverage index for the companies offering this service. An example of this work appears below for Company ABC, which had net income of $7,490,000, assets of $65,700,000, and total equity of $37,500,000.
Return on equity was found to be:
= $7,490,000 / $37,500,000, or 19.97%
Return on total assets was found to be:
= $7,490,000 / $65,700,000, or 11.40%
Finally, the company's financial leverage index was found to be:
= 19.97% / 11.70%, or 175%