The financial leverage shows the way that a company is funding its operations. A company can choose between debt and capital. There are many theories (Modigliani and Miller theories for example) that try to explain the optimal financing for a company. The leverage ratio shows how much debt a company has raised compared to its capital. Debt tends to be cheaper but it is also riskier (interest costs raise and the company can get closer to bankruptcy). Equity is more expensive (investors are the last to receive their money back when a company is liquidated). On the other hand, equity is less risky as the companies can choose not to give dividends when they have no profits or when they run short in funds.
On the other hands, raising equity can make the shareholders particularly unhappy since the holdings and thus the voting power can change.
The financial leverage captures the capital structure of the company. In other words, it gives you an idea of the way that the company is funded. There are two different ways to raise funds, either by raising equity or by raising debt.
The financial leverage is a ratio that shows how much debt a company has raised compared to it’s equity. The simplest ratio formula is debt (interest bearing debt) divided by equity.
Raising debt has benefits but also disadvantages. Debt tends to be cheaper and the interest costs are also tax deductible. However, raising too much debt might drive the company to insolvency.