Financial Leverage
Financial leverage ⇒ is the use of debt to increase earnings. Interest is the cost of using debt to finance operations. Interest is a fixed charge because unlike dividends, interest must be paid whether or not the firm is profitable. The use of financing that carries a fixed charge is called financial leverage.
Financial leverage is a part of solvency analysis. Financial leverage magnifies the effect of both managerial success (profits) and managerial failure (losses). When financial leverage is being used, an increase in earnings before interest and taxes (EBIT) will cause an even greater proportionate increase in net income, and a decrease in EBIT will cause an even greater proportionate decrease in net income.
Financial leverage ratios measure a company’s use of debt to finance its assets and operations. Financial leverage can also be defined as the percentage of fixed cost financing in a firm’s overall capital structure, because the increased amount of debt causes the company’s financial costs (interest expense) to increase.
Higher financial leverage indicates that shareholders are accepting greater risk because the higher the leverage, the more fixed interest costs the company will be required to pay. On the other hand, if the company generates more net income from its investment of the borrowed funds than is required to service its debt costs for the borrowed funds, the shareholders will benefit from the high financial leverage because profits will increase.
Financial leverage magnifies both profit and loss and therefore requires careful consideration from a financial manager.
Financial leverage is successful if the firm earns more by investing the borrowed funds than it pays in interest to use them. It is not successful if the firm is not able to earn more by investing the borrowed funds than it pays in interest for them.
Benefits of Using Financial Leverage
- If financial leverage is used successfully, the interest expense paid on the debt capital will be less than the return earned from investing it, and the excess return will benefit the equity investors.
- Interest paid on debt is tax-deductible, and its tax deductibility effectively reduces interest as an expense.
Limitations of Using Financial Leverage
- • The financial leverage may be used unsuccessfully, and if so, the return earned from investing the debt capital will be less than the interest expense paid on it, which will hurt the value of the equity investors’ investments.
- Too much financial leverage causes the cost of all of the company’s capital to increase because investors will perceive greater risk and will require a greater return on their investment.
A company’s financial leverage is measured by its financial leverage ratio and by its degree of financial leverage.