Question

What is financial leverage? How, and under what conditions, can financial leverage benefit a company? How, and under what conditions, can it harm a company?

Answer 1

Financial leverage may be defined as ' the use of funds with a fixed cost in order to increase earnings per share.'In other words, it is the use of company funds on which it pays a limited return. Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing return to stock holders

Financial Leverage = EBIT / EBT

Degree of financial leverage

It is the ratio of the percentage increase in earnings per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT). Financial Leverage (FL) is also defined as 'the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on EPS

Degree of Financial Leverage (DFL) = % Change in EPS / % Change in EBIT

CONDITIONS IN WHICH FINANCIAL LEVERAGE CAN BENEFIT A COMPANY:

1. Powerfull access to capital: Financial leverage multiplies the power of every rupees you put to work. Ifused successfully , leveraged finance can accomplish much more that you could possibly achieve without the injection of leverage

2. Ideal for acquisition, buyouts: Because of the additional cost and risks of adding up on debt, leveraged finance is best suited for brief periods where your business has a specific growth objective, such as conducting an acquisition, management buyout, share buyback or a one time dividend.

CONDITIONS IN WHICH FINANCIAL LEVERAGE CAN HARM A COMPANY:

1. Risky form of finance: Debt is a source of funding that can help business grow more faster. Financial leverage is even more powerful, but the higher-than-normal debt level can put a business into too high a state of leverge and that magnifies exposure to risk.

2. More costly: Products which are finacially leverged , like leveraged loans & high yield bonus, pay higher interest rates to compensate investors for taking on more risk.

3. Complex: The financial instruments involved , such as subordinated mezzanine debt, are more complex . This complexity calls for additional management time and involves various risk.