The leverage formula

The leverage formula is a formula to calculate the return on equity based on return on assets, interest rate to lenders and financial leverage.

The leverage formula shows that the return on equity increases if the return on assets exceeds the interest rate to the lender and the debt to equity ratio increases. When you are working with the leverage formula you need, however, to be aware that risk and return are related. If you increase the leverage (debt to equity ratio) to get a higher return on equity this also means a higher risk. When using the leverage formula, you must be aware of the relationship between risk and return. For example, if the return on assets is below the interest rate to lenders, a company will increas its losses with a higher leverage.

The leverage formula: ROE = ROA + (ROA - AIR) * (D/E)

where:
ROE - return on equity
ROA - return on assets
AIR - average interest rate (interest expense / debt)
D/E - debt / equtiy