What is Financial Leverage?
Financial leverage is the use of borrowed funds (debt) to finance a company’s assets with the goal of magnifying returns to shareholders. While leverage can boost return on equity when operating returns exceed the cost of debt, it also amplifies losses and increases financial risk and bankruptcy exposure.
How It Works
- Common leverage ratios: debt-to-equity, debt-to-assets, and equity multiplier.
- Degree of Financial Leverage (DFL) = % change in EPS / % change in EBIT.
- Higher leverage boosts return on equity if return on assets exceeds the after-tax cost of debt.
- Leverage increases fixed financing costs (interest), so earnings become more volatile.
- Excessive leverage raises default risk and tightens lender covenants.
Saudi Context
Saudi banks (SAMA-supervised) follow Basel III capital adequacy rules that effectively cap their leverage. CMA-regulated REITs must hold debt-to-asset ratios below 50%. Saudi family-owned holding groups historically use moderate leverage compared to global peers, though the Vision 2030 mega-project era has driven sukuk issuance to higher levels.
Example
A construction company holds SAR 600 million of debt and SAR 200 million of equity. Debt-to-equity = 3.0x, a high leverage profile. If EBIT rises 10%, after-tax EPS may rise 25% due to fixed interest costs, but a 10% EBIT drop could push EPS down 25% in the opposite direction.