Financial Leverage in common way is understood as the use of debt to acquire additional assets. Financial leverage is also known as trading on equity.
In general it is taken as:-
Earning before Interest and Taxes
Earning before tax
% Change in Earning Per Share
% Change in Operating Income
But, Financial Leverage is more than this. It is one of the most interesting and difficult concept. Most often it involves buying more of an asset by using borrowed funds, with the belief that the income from the asset or asset price appreciation will be more than the cost of borrowing. Almost, always this involves the risk that borrowing costs will be larger than the income from the asset, or that the value of the asset will fall, leading to incurred losses.
The most intimate relationship most of us have with leverage is our home mortgage. In the vast majority of cases, over many decades, this structure has been positive and transformative to the buyer. However, there are two conditions necessary for financial leverage to actually become power.
The 1st one is : the borrower must be able to make his payments, or he risks repossession.
The 2nd one is : the assets underlying the leverage hold his value.
As leverage accentuates the profit when assets value rise, it decimates return when values fall. Without these conditions, the benefits of leverage becomes a huge liability.
The main objective of introducing leverage to the capital is to achieve maximization of wealth of the shareholders. Besides this,
- Financial leverage can be very useful to a firm if properly used under the right conditions. For firms in industries that have a degree of stability and/or show growth, the use of debt is recommended because of the positive aspects of financial leverage.
- Financial leverage makes the company to take a decision, whether they can go for further public issue or not.
Importance and Benefits
The need of lever and fulcrum enables a worker to exert force far in excess of his unassisted strength. Likewise in the field of finance, the use of debt or borrowing to increase the size or profitability of a venture is called leverage. While borrowing incurs interest expense and risk, it also yields rewards.
Further financial leverage helps in:-
Magnification of shareholders’ profits :
If a company is solely financed by shareholder equity, then its profitability to the shareholders will change in proportion to its own change in profitability.
For eg.,if profits increase by 10 %, the shareholders’ dividends and share value will increase by 10 %. If the firm is leveraged, then that increase in profitability of the operation will not increase the payment needed to service the debt. Thus, the value of shares or dividends to a greater degree than the increase in the operation’s profitability.
Improvement in Credit Rating :
A firm that successfully uses leverage demonstrates by its success that it can handle the risks associated with carrying debt. This can become an important factor when additional financing is needed. Not only will loans more likely be available, but they will be available at more attractive interest rates.
Powerful access to Capital :
Financial leverage multiplies the power of every dollar you put to work. If used successfully, leveraged finance can accomplish much more than you could possibly achieve without the injection of leverage.
Ideal for acquisitions buyouts:
Because of additional cost and risks of bulking up on debt, leveraged finance is best suited for brief periods where your business has a specific growth objective, such as conducting an acquisition management buyout, share buyback or a one-time dividend.
Use of debt to increase the expected return on equity is referred to as financial leverage. It is beneficial to those who can deal with the risk of failure and repay the debt. Excessive amount of anything is harmful. So, before raising the amount of debt, necessary things are to be considered and taken care of. Financial leverage, if it is strong enable to negotiate well and set the price in industry. Thus, it is important to maintain financial leverage.
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