Optimal leverage depends on each organization, its objectives, and its operating methods. Generally speaking, it allows you to optimize investments even when you don’t have enough equity capital to invest. In this post, we analyze this concept and encourage you to calculate it, while also providing useful information to help you evaluate it effectively.
1. What Is Financial Leverage, and Why Should You Calculate It?
The financial leverage or debt ratio allows you to analyze an organization’s financial health. It is just as unwise to accumulate excessive debt as it is to miss out on the opportunity to optimize investments out of fear of going into debt. Obviously, return on investment is a crucial factor in this investment analysis.
Financial leverage offers the possibility of investing with borrowed money and, if a good return on investment is achieved, generating more resources. Therefore, the optimal approach is one that facilitates obtaining more investment capital and higher returns.
In more technical terms, it can be described as follows:
- It drives an increase in the return on equity.
- It uses the return on total capital as a benchmark.
- It relies on the use of borrowed capital.
In other words, you can think of it as the difference between equity and the capital that is, in fact, being used in a financial transaction or in the aggregate of all such transactions within a company.
2. Optimal Leverage: A Desired Goal
All companies aim to improve their return on investment. To do so, they rely on financial leverage as a strategy to optimize their investments. Raising external capital becomes an advantage for generating higher revenue—whether through sales or other means—compared to relying solely on equity.
Taking on debt is not a bad thing, as long as it is not done to excess and good returns are achieved on the resulting operations. In fact, the optimal debt ratio implies that the cost of borrowed capital is lower than the return on equity, allowing the company to generate profits. Its capital yields higher returns and pays off better!
3. Pros and Cons of Leverage Ratios
Keep in mind that there are different ways to analyze debt on an organization’s balance sheet. The leverage ratio only considers debt relative to equity. Calculating it yields a standardized figure that allows for comparisons. However, to assess a company’s historical performance, it is always more useful to analyze trends within the industry.
With this calculation, financial institutions obtain an objective indicator for assessing risk. The higher the debt, the greater the risk. Internally, this indicator is excellent for managing debt, forecasting future cash flows, and providing benchmarks for optimizing investments.
The main limitation of these debt ratios is that they provide conditional warning signs. Suboptimal leverage—with too much debt—does not always imply a poor financial situation. On their own, they do not provide complete information, so it is necessary to correlate them with other data.
4. How to Calculate Your Optimal Leverage?
First of all, you need to learn how to calculate the leverage ratio. Basically, it involves dividing total liabilities on the balance sheet by shareholders’ equity. These liabilities include both long-term and short-term liabilities plus shareholders’ equity.
This calculation is useful for comparing companies of a similar nature or tracking the performance of a single organization over time. Now, when can we speak of optimal leverage?
Below, we detail the most commonly used interpretations:
- It is considered low when it is below 25%. This reflects a potential loss of opportunities due to not using external debt to achieve a higher return on investment.
- It is considered optimal when it falls between 25% and 50%. This is the figure you should aim for.
- It is considered high when it exceeds 50%. In these cases, it entails a definite financial risk.
That said, these general guidelines must be qualified by your own historical analysis and that of your competitors. For example, a company that needs funds to undertake a project has two options: to use its own resources through a capital increase, or to take out a loan. Only in the latter case would the company be leveraging itself.
The conclusion is clear: optimal leverage is a key metric you must take into account. But more important than achieving it is optimizing your investments. At WorkCapital, we help you achieve that.
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