Introduction:
Financial leverage refers to the use of debt in a company’s capital structure to enhance potential returns to shareholders. It involves employing fixed-cost capital—such as loans, debentures, and preference share capital—within the firm’s total capitalization. This strategy can magnify both gains and losses, making it a critical concept in financial management.
Meaning of Financial Leverage
Financial leverage reflects a firm’s ability to utilize fixed financial costs in a way that amplifies the impact of changes in *Earnings Before Interest and Taxes* (EBIT) on *Earnings Per Share* (EPS). In simpler terms, it is the practice of using debt capital to increase the return on equity. By doing so, any variation in EBIT results in a proportionally larger variation in EPS.
Key characteristics of financial leverage include:
1. It pertains to the liabilities side of the balance sheet.
2. It is directly related to the firm’s capital structure.
3. It is associated with financial risk.
4. It influences earnings after tax and EPS.
5. It can be favourable or unfavourable—unfavourable when the firm’s earnings are lower than the cost of borrowed funds.
Computation of Financial Leverage
Financial leverage is calculated using the following formula:
Financial Leverage=EBIT/EBT
Where:
EBIT = Earnings Before Interest and Taxes
EBT = Earnings Before Tax (after deducting interest)
Some experts define financial leverage in the context of the relationship between EBIT and EPS, showing the percentage change in EPS relative to the percentage change in EBIT.
Behaviour of Financial Leverage
The behaviour of financial leverage is assessed through the **Degree of Financial Leverage (DFL)**, which measures the sensitivity of EBT or EPS to changes in EBIT.
Two common formulas are:
DFL=%Change in EBT/% Change in EBIT
or
DFL=% Change in EPS/% Change in EBIT
A higher DFL indicates greater sensitivity of returns to changes in operating income, implying higher financial risk.
Composite (Combined) Leverage
Both operating and financial leverage contribute to magnifying returns. While operating leverage focuses on the impact of fixed operating costs, financial leverage emphasizes fixed financial costs. Composite leverage** measures the combined effect of both types on taxable profits.
Formula:
Composite Leverage= Operating Leverage x Financial Leverage
or
Composite Leverage= Contribution/EBT
The Degree of Combined Leverage (DCL) = % Change in EPS/% Change in Sales Volume
Conclusion
Financial leverage is a powerful tool in corporate finance, capable of enhancing shareholder returns but also increasing financial risk. Understanding its computation, behaviour, and interaction with operating leverage is essential for informed decision-making in capital structure management.
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