Return on Financial Leverage

 

Return on Financial Leverage (ROFL) measures the effect of debt on a company’s Return on Equity (ROE).

ROFL is calculated by subtracting Return on Assets (ROA) from Return on Equity (ROE).

ROFL = ROE – ROA.

In essence, ROFL shows the amount of the Return on Equity that is due to use of debt. Rewriting the above formula illustrates that Return on Equity is the sum of Return on Equity and Return on Financial Leverage:

ROE = ROA + ROFL.

ROFL examines whether debt is being used to enhance profits efficiently. If a company's return on assets exceeds its cost of debt, leverage increases ROE, benefiting shareholders. However, if the cost of debt is higher than the return on assets, leverage reduces ROE, making the company’s financial position riskier.

Example 1: Consider two firms, A and B. Each have $1 million in assets and generate $100,000 in net income, giving each of them an ROA of 10% (ROA = (Net Income / Assets) x 100% = ($100,000 / $1 million) x 100% = 10%).

Firm A:

Firm A is fully equity-financed and has no debt. Firm A equity = $1 million.

Firm A’s ROE = (Net Income / Equity) x 100% = ($100,000 / $1 million) x 100% = 10%.

Firm A’s ROA = (Net Income / Assets) x 100% = ($100,000 / $1 million) x 100% = 10%.

Firm A’s ROFL = ROFL = ROE – ROA = 10% - 10% = 0%.

This shows Firm A’s net income results entirely from shareholder equity. There is no financial leverage being used to generate profits.

Firm B:

Firm B has financed half of its assets with $500,000 of debt. For simplicity, we will ignore the cost of financing the debt.

Firm B’s equity = $500,000 (Equity = Assets – Liabilities = $1 million - $500,000 = $500,000).

Firm B’s ROE = (Net Income / Equity) x 100% = ($100,000 / $500,000) x 100% = 20%.

Firm B’s ROA = (Net Income / Assets) x 100% = ($100,000 / $1 million) x 100% = 10%.

Firm B’s ROFL = ROE – ROA = 20% - 10% = 10%.

This shows Firm B’s Return on Equity results from equal parts assets and financial leverage.

Interpreting ROFL can be difficult:

A high ROFL is not necessarily detrimental. Responsible use of debt can enhance returns. Debt can be far cheaper than equity, depending on market conditions.

However, short-term gains from use of leverage can obscure long-term risks. The firm must have the resources to repay the debt, including interest. Our example does not include the cost of financing the debt. In actual practice, this cost will reduce net income.

Firms with similar ROFL values may have vastly different financial health depending on their debt structures and interest rate environments. Investors must consider other factors, such as management’s ability to handle leverage and market conditions, rather than relying solely on ROFL as an indicator of financial strength.

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