Financial Leverage

Financial Leverage:

A company can raise its fund from a variety of sources, such as debt, preference share capital and equity capital. The rate of interest on debt is fixed irrespective of the company's Rate of Return (RoR). The company has a legal binding to pay interest on debt. The rate of preference dividend is also fixed but the preference dividends are paid when the company earns profit. The equity shareholders are entitled to the residual income. The rate of equity dividend is not fixed and depend on the dividend policy of the company.

The use of fixed charges source of fund such as debt and preference capital along with the owner's equity in the capital structure is described as financial leverage or trading on equity.

"Financial Leverage exists whenever a firm has debts or other sources of fund that carries fixed charges"

"Ability of a firm to use fixed financial charges to magnify the effects of changes in Earnings before interest and taxes(EBIT) on the firm's earning per share is financial leverage".

The financial leverage can be high or low. If the proportion of fixed cost capital is high, it will have a high financial leverage and if the proportion of variable cost is high, there will be low financial leverage. If a company is having low proportion of variable capital, this solution is also known as trading on equity.

The financial leverage may be favourable or unfavorable. If the cost of borrowed fund is less than the overall return of fund, it will be favourable financial leverage and otherwise, it will be unfavorable financial leverage.

Computation of financial leverage/ measurement of degree of leverage:

Financial Leverage = [EBIT ÷ (EBIT - I)]
                                    =(EBIT ÷ EBT)
                                    =(OP ÷ PBT)

Here,

EBIT= Earnings before interest and taxes

EBT = Earnings before taxes
I       = Interest
OP   = Operating Profit
PBT = Profit Before Taxes

Following 3 situations of capital structure may be there for computation of financial leverage:

1. When there is equity share capital and debt capital.

2. When there is equity share capital and preference share capital.

3. When there is equity share capital, preference share capital and debt capital.