A basic decision faced by financial managers is the extent to which a firm should rely on borrowed capital. Shakespeare’s adage “neither a borrower nor a lender be” is poor business advice. It is beneficial for most corporations to rely on debt to some extent, because the interest expense on debt is tax deductible, while dividends paid to stockholders are not. The degree of reliance on debt, or financial leverage, is measured as the ratio of debt to assets:
Financial leverage = Total liabilities / Total assets
Financial leverage ratios are widely used by analysts to assess the risks of debt and equity securities. Firms with debt percentages that are substantially above their industry averages tend to have a higher likelihood of default on debt payments. As a result, high financial leverage is associated with lower bond quality ratings and therefore higher borrowing (interest) costs. Equity investments have also been found to be riskier for firms with high financial leverages. The share prices of highly leveraged firms tend to be more volatile than the share prices of firms with lower financial leverage.