Question

Which of the following formula reflects the firm’s financial leverage?

Question 11 options:

	1) EBIT / Interest income
	2) (Total Liabilities) / (Total Assets)
	3) (Current Assets) / (Current Liabilities)
	4) (Accounts Payables) / (Annual Purchases / 365)

Answer 1

Financial leverage refers to making use of borrowed money to purchase assets in the organisation. Financial leverage is used to increase the return on equity.

We can calculate the financial leverage of the firm as follows

= Total Debt / Total Equity

we can evaluate the given options as follows

1) EBIT / Interest income: Financial leverage is determined by the total liabilities against total equity, so this option is not correct.

2) Total Liabilities / Total Assets : This formula represents the debt ratio of an organisation by comparing the total liabilities of the company against its total assets. So, this is also not the formula to calculate the financial leverage.

3) Current Assets / Current Liabilities : This formula represents the current ratio of an organisation by comparing the current assets of the company against the current liabilities. So, this is also not the formula to calculate the financial leverage.

4) Accounts Payables / Annual Purchases / 365 : This formula represents the Accounts Payable turnover ratio, which is the number of days taken by the company on an average to pay its debtors. This formula again is not useful for calculating the financial leverage.

All the options given donot satisfy the requirement for calculating the firm's financial leverage.