Financial Leverage

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Description of Financial Leverage. Explanation.

 

Financial Leverage works like a lever or a pullyDefinition Financial Leverage. Description.


Financial Leverage (FINLEV), also known as Gearing, is a technique to multiply gains and losses. It reflects the amount of debt used in the capital structure of a firm, compared to the amount of equity it uses.

 

Benefits of Financial Leverage

  • By utilizing borrowed money (debt) rather than equity to fund its operations, a business leverages its equity, because it will require less equity capital, and any profit (or loss) can be shared among a smaller base of shareholders.
  • In this way, debt can be used to magnify the rate of return on Shareholders' Equity.

Tax Deductibility of Debt and Financial Leverage

When you compare the costs of the 2 main ways of obtaining capital for a firm: debt and equity, interest payments on debt are typically tax-deductable, while dividends on equity are not. This tax effect means for a business that obtaining capital via debt is cheaper (net, after tax). So if it obtains debt, we can also say that its financial leverage is influenced (in a positive way) because its Return on Equity (ROE) will be increased.


Calculation Financial Leverage. Formula

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:

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 (=operating income, operating earnings) of the firm will result in a 139% in the EPS.


Disadvantages of Financial Leverage

  • FINLEV is a two-edged sword: it also multiplies losses!
  • 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.

In debt contracts, the borrower may be obliged to maintain certain levels of gearing. Such clauses are called Affirmative Debt Covenants.


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