Chartered Financial Analyst (CFA) Level 1 Practice Exam

How is financial leverage calculated?

1. Average total equity / average total assets

2. Average total assets / average total equity

3. Average total assets + average total equity

4. Average total assets - average total equity

The correct answer is: Average total assets / average total equity

Financial leverage is a measure of the proportion of debt a company uses to finance its assets. It indicates how much of the company’s assets are financed by equity versus debt. The correct calculation is expressed as the ratio of average total assets to average total equity. By looking at this ratio, investors can ascertain how much asset value corresponds to each dollar of equity invested. A higher ratio suggests that the firm is using more debt relative to equity, indicating higher financial risk, but potentially also higher returns on equity during profitable periods. The other methods do not accurately capture the relationship between assets and equity in terms of financial leverage. For instance, simply averaging total equity and total assets or subtracting them does not convey insight into how leveraged the firm's capital structure is. A straightforward ratio is essential to accurately represent the risk and return dynamics inherent in leveraging assets through debt.