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Just did a question on this topic and I'm a bit confused. The answer indicates that issuing common stock will increase financial leverage.
Leverage is debt, so how can issuing stock (equity) increase leverage?
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ROE = Net Profit Margin X Asset Turnover X Financial Leverage
i.e:
(Income/Sales) X (Sales/Assets) X (Assets/Equity)
When equity # goes up, the last number financial leverage will come down.
Equity = Assets - Debt
A company can decrease its equity (as % of assets) by increasing its debt. If the equity in the denominator increases, the overall financial leverage number will be lower. Please correct me, if I am wrong.
Can it be a typo?
I agree with @vijay - financial leverage should decrease instead of increase. As @vijay mentioned financial leverage is % of assets over equity (or 1-debt).
Putting it in simple terms, a business is financed either by equity or debt. By issuing common stock, you're increasing the equity side of your financing, therefore debt takes up a lower percentage of your company's financing, therefore financial leverage is lower.
I was having trouble understanding how an equity adjustment affect what I understood to be fundamentally a debt-based metric (financial leverage).
Now say A = 4, L = 2, S.E. = 2. The leverage factor (Avg. Assets / Avg. Equity) = 4/2 = 2. Now say a company issues $2 in equity but keeps L constant. The equation would currently look like the following: A = 4, L =2, S.E. = 4 (indicates the $2 increase in book value of equity); to balance the equation Assets will increase by a factor of $2 (indicates the $2 increase in cash, which is a current asset). The new leverage factor would now be 6/4 = 1.5. Thus showing the decrease in the leverage factor. It is important to remember that although we did not touch Liabilities, we did increase assets due to an increase in cash, however since both numerator and denominator increase by the same amount, and the fact that the numerator is larger, it causes the ratio to decrease.
Hope this helps as well