Question

What are the fundamental principles of financial leverage?

Answer 1

Financial leverage is the use of fixed cost sources of funds like debt and preferred stock to magnify the return to common stockholders.

It takes advantage of the fact that for debt and preferred stock, the dollar return payable is the same, irrespective of the net income that is made, subject of course to the fact that debt interest has to be paid even in the absence of sufficient profits [EBIT] and preferred dividend need not be paid if net income is insufficient.

The fundamental principles of use of financial leverage are:

*The Basic earning power of the firm, calculated as EBIT/Total assets and expressed as %, should be more that the rate of return payable on debt. [For paying preference dividend the NI should be sufficient].

*This leveraging effect will be positive only up to a certain % of debt in the capital structure, which, is considered optimal. Beyond such a level of debt, financial leverage will have lesser effect and ultimately negative effect. The reason for this phenomenon is that, beyond the optimum level of debt in the capital structure, the firm will be considered to be increasing risky with increase in debt and the suppliers of debt capital and equity capital will ask for more returns to compensate for the increase in risk. The increase in risk will also get reflected in the P/E ratio.

*To use financial leverage, the operating leverage should be lower, so that the combined leverage [product of financial leverage and operating leverage] is kept at an optimum level. More the DCL more the risk.

*Too high leverage can be devastating in times of lower performance in sales.

*Leverage once committed cannot be altered easily. Restructuring is costly and will have unfavorable market perception.