Explain briefly what causes financial leverage?

A firm finances its assets /operations through some combination of equity and debt. Financial leverage is the extent to which a business is using the borrowed money to finance its assets and operations.

It is measured as the ratio of debt to debt plus equity. The greater the amount of debt, the greater the financial leverage.

The borrowed money is used to increase production volume, and thus sales and earnings.

Financial leverage helps in designing the appropriate capital structure. One of the objectives of planning an appropriate capital structure is to maximize return on equity shareholders' funds or maximize EPS.

Financial leverage is caused by a higher degree of financial obligations with fixed interest cost i.e., debts and preferred equity etc.

The use of borrowed money to increase production volume, and thus sales and earnings. It is measured as the ratio of total debt to total assets. The greater the amount of debt, the greater the financial leverage.

Since interest is a fixed cost (which can be written off against revenue) a loan allows an organization to generate more earnings without a corresponding increase in the equity capital requiring increased dividend payments (which cannot be written off against the earnings). However, while high leverage may be beneficial in boom periods, it may cause serious cash flow problems in recessionary periods because there might not be enough sales revenue to cover the interest payments.