Question

What is financial leverage? What are the benefits and risks associated with financial leverage?

Answer 1

Financial leverage can be defined as the use of debt to finance your asset instead of equity. An accounting equation Asset = debt+ equity. So in order to increase your assets by means of increasing your debt is financial leveraage.

Its formula is =total debt/total assets.

Example- suppose you are running a small business and need to buy an asset of $1000. and for that you are willing to invest your $500 and taking a bank loan of $500. In this case your investment will be equity and bank loan will be debt.

Here financial leverage = debt portion/ total asset = 500/1000= 50%.

Benefits with fianacial leverage

1.if the profit is higher than debt interest repayment. it enhances shareholders profit.

2.also using debts helps to get tax benefits as interest expense in tax deductible

3. it helps the company to be with cashflows.

Risk associated with financial leverage

1. if the balanced approach is not taken care of while taking loans, and the company is not able to repay the loan. it will face risk of failure.

2. Higher financial levereage means lower equity which might makes company to make descisions not in favour of shareholders.

3. Company might loose its credibilty if they are unable to repay loans