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Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage.Mary uses $400,000 of her cash to purchase40 acres of land with a total cost of $400,000. Mary is not using financial leverage.Sue uses $400,000 of her cash and borrows $800,000 to purchase120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money. If the properties owned by Mary and Sue increase in value by25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a25% return. Sue's land will sell for $1,500,000 and will result in a gain of $300,000. Sue's $300,000 gain on her $400,000 investment results in Sue having a75% return. When assets increase in value leverage works well. When assets decline in value the use of leverage works against you. Let's assume that the properties owned by Mary and Sue decrease in value by10% from their cost and are then sold. Mary will have a loss of $40,000 on her $400,000 investment---a loss of10% on Mary's investment. Sue will have a loss of $120,000 ($1,200,000 X10%) on her $400,000 investment. This is a loss of30% ($120,000 divided by $400,000) on Sue's investment.
Simply Financial leverage is how intensive the entity is depending on debt vs equity in its financial structure.
High leveraged entities is in a risky position if the future cash inflows are not well managed as poor collections may lead to insolvency in the near future and may lead to bankruptcy in the long run but at the same time the entity is taking the benefit of tax shield for the interest expense while the cost of equity "dividends" is not. High leverage is highly recommended for entities at growing and maturity phases in the business life cycle.
On the other hand, low leverage is recommended at the start up and decline phases in the business life cycle when the company is expecting a decline in cash flows and net profits.
Is the degree of risk assumed by a firm of use fixed cost in financial structure.
which mean the relation between Net income and operation income let us say if one company had alot of debt so any reduce in there operation income will be high risk based on the loan charges or interst which we should pay
Financial leverage is a term that describe the capital structure of a business entity. It shows generally in percentage term the presence of debt in the capital structure of the entity.
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.
Well, The use of the fixed charges sources of fund , such as debt and preference capital along with the the owners equity in the capital structure , is described as Financial Leverage or Trading On Equity
Degree Of Financial Leverage =% Change in EPS / % Change in EBIT
