Financial Leverage

Description of Financial Leverage. Explanation.

Definition Financial Leverage. Description.

Financial Leverage (FINLEV) is the degree to which a business is utilizing borrowed money rather than equity to fund its operations. It reflects the amount of debt used in the capital structure of the firm. Debt is used to magnify the rate of return on shareholders' equity.

The degree of this leverage is defined as the percentage change in Earnings per Share (EPS) that results from a given percentage change in Earnings Before Interest and Taxes (EBIT), and it is calculated as follows:

Calculation Financial Leverage. Formula

FINLEV = (Percentage change in EPS) : (Percentage change in EBIT)

Suppose you find a FINLEV of 1.39 for a firm, this then means that a 100% increase in the EBIT of the firm will result in a 139% in the EPS.

FINLEV is a two-edged sword: companies that are highly financially leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future.

Compare also: Return on Equity (ROE)

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End of description Financial Leverage. An explanation.