What is the financial leverage? State the uses of financial leverage

Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of EBIT on EPS of the company. A company’s sources of funds fall under tow categories – those which carry a fixed financial charge – debentures, bonds and preference share and those which don’t carry any fixed charge – equity shares. Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the company’s income stream. Such expenses have nothing to do with the firm’s performance and earnings and should be paid off regardless of the amount of EBIT. It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favorable or positive leverage. Unfavorable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to do as “trading equity”.

Use of financial leverage studying DFL of various levels makes financial decision-making on the use of fixed sources of funds for funding activities easy. One can assess the impact of changes in EBIT in EPS.

Like operating leverage, the risks are high at high degrees of financial leverage. High financial costs are associated with high DFL. An increase in financial costs implies higher level in financial costs implies higher level of EBIT to meet the necessary financial commitments. A firm not capable of honoring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On the one hand trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firm’s mix of sources of funds. One main goal of financial planning is devise a capital structure in order to provide a high return to equity holders. But at the same time this should not be done with heavy debt financing which drives the company on to the brink of winding up.