Financial Leverage

Financial leverage focuses on how a company's financing decisions impact its earnings available to shareholders. It arises from the use of fixed financial charges in the firm's income stream, such as interest payments on debt or preferred dividends.

Core Concepts

Fixed Financial Charges: Costs that remain constant regardless of the company's earnings before interest and taxes (EBIT). These include interest payments on bonds and debentures, and preferred stock dividends.
EBIT as the Pivotal Point: Financial leverage examines how changes in EBIT affect the earnings available to equity holders after fixed financial charges are paid.
Magnified Returns: When a company uses financial leverage effectively, changes in EBIT have a multiplied effect on earnings per share (EPS). This "trading on equity" can lead to higher returns for shareholders.
Increased Risk: Financial leverage also increases financial risk. If EBIT is insufficient to cover fixed financial charges, shareholders bear the burden of lower earnings and potential losses.

The Definition of Financial Leverage

Financial leverage is a company's ability to use fixed financial charges to magnify the effects of changes in EBIT on its earnings per share. In essence, it involves obtaining funds at a fixed cost with the expectation of increasing returns to shareholders.

Favorable vs. Unfavorable Leverage

Favorable (Positive) Leverage: Occurs when the return on assets purchased with borrowed funds exceeds the fixed cost of using those funds (interest or dividends). The difference between the earnings and the fixed cost goes to equity holders.
Unfavorable (Negative) Leverage: Occurs when the return on assets is less than the fixed cost of borrowing. Shareholders bear the burden of lower earnings.

Example: Illustrating Financial Leverage

A company has Rs 1,00,000 in 10% debentures and 5,000 equity shares outstanding. The company is in the 35% tax bracket. Let's analyze the EPS at different EBIT levels:

EBIT (Rs)	Interest (Rs)	Earnings Before Taxes (Rs)	Taxes (Rs)	Earnings After Taxes (Rs)	EPS (Rs)	% Change in EBIT	% Change in EPS
30,000	10,000	20,000	7,000	13,000	2.6	-40% from base	-50% from base
50,000 (Base)	10,000	40,000	14,000	26,000	5.2	-	-
70,000	10,000	60,000	21,000	39,000	7.8	+40% from base	+50% from base

Observations:

EBIT Increase: A 40% increase in EBIT leads to a 50% increase in EPS.
EBIT Decrease: A 40% decrease in EBIT leads to a 50% decrease in EPS.

Measuring Financial Leverage: Degree of Financial Leverage (DFL)

The Degree of Financial Leverage (DFL) quantifies the extent of financial leverage.

DFL Definition: The percentage change in EPS for a given percentage change in EBIT.
Formula: DFL = (% Change in EPS) / (% Change in EBIT)

If DFL is greater than 1, financial leverage is present. The higher the DFL, the higher the financial leverage, and the more sensitive EPS is to changes in EBIT. When there is no fixed-charged financing, there will be no financial leverage.

Impact and Risk

High Financial Leverage (High DFL): Greater potential for increased EPS when EBIT is strong, but significantly higher risk of decreased EPS when EBIT declines.
Low Financial Leverage (Low DFL): More stable EPS but less potential for maximizing returns to equity owners.

Financial Risk: The risk that a company won't be able to cover its fixed financial costs (interest payments, preferred dividends). Failure to meet these obligations can lead to financial distress or even bankruptcy.

Financial risk is the risk of a firm not being able to cover fixed financial costs.