Describe Financial Leverage

Question

Briefly describe Financial Leverage? In what manner it is calculated? What does low or high financial leverage signify?

Answer 1

Financial leverage is the leverage in that a company settles on to finance majority of its assets by taking on debt. The leverages have been concerned by investors and companies to produce more returns on their assets. This employment of leverage does not guarantee triumph and raises the possibility of excessive losses that becomes greater in high leverage positions. Firms employ this leverage when they are not capable to increase sufficient capital by issuing shares in the market and not capable to meet their business wants. When firm takes on debt it sees that at that time how is the return on assets and for a firm it must be higher than the interest on loan.

The computation of financial leverage carries out in subsequent steps:-

i) Computation of total debt is carried out by the company that contains short term debt and long term debt.

ii) Computation of total equity takes place in the company through shareholders to find out the equity they multiply number of outstanding shares by stock price. This amount is embodied as shareholder equity.

iii) To compute financial leverage ratio divide total debt by total equity.

iv) If company has high financial leverage ratio than it could be a signal of financial weakness. This can as well lead to bankruptcy if the company is highly leveraged.   

High financial leverage specifies the risky investment made through the company's shareholders. Low financial leverage specifies that management has implemented a very good approach towards the debt capital. This reduces the management decision making on earning per share.