What is Financial Leverage?
Financial leverage measures how much debt a company uses to finance its assets. The DuPont decomposition breaks ROE into profit margin × asset turnover × financial leverage (total assets / equity). A company with $100M equity and $100M debt has 2x leverage. As long as the return on assets exceeds the cost of debt, leverage amplifies ROE for shareholders.
The Double-Edged Sword
With 5% ROA and 3% borrowing cost, the 2% spread is amplified by leverage, boosting ROE to 7%. But if ROA drops to 2% during a recession while debt costs remain at 3%, the negative spread is equally amplified, crushing ROE to 1%. High leverage transforms moderate business risk into extreme equity risk.
What Investors Should Check
When you find a company with high ROE, use DuPont analysis to identify the source. ROE driven by high margins or efficient asset use is healthy. ROE inflated primarily by financial leverage is fragile. Companies with equity ratios below 30% (leverage above 3.3x) face elevated bankruptcy risk during downturns. Understanding the quality of ROE, not just its level, is the essence of financial analysis.