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The use of fixed charges (or interest) bearing sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure of a company is described as financial leverage or gearing or trading on equity.

The use of fixed charges (or interest) bearing sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure of a company is described as financial leverage or gearing or trading on equity.

The use of term trading on equity is derived from the fact that the debt is raised on the basis of the owner’s equity - the equity is traded upon. Since the debt provider has limited participation in the company’s profits he will insist on to protect his earnings and protect values represented by ownership equity.

Financial leverage is the name given to the impact on returns of a change in the extent to which the firm’s assets are financed with borrowed money. The financial leverage is employed by a company only when it is confident of earning more return on fixed charge funds than their costs. In case the company earns more than the derived surplus will increase the return on the owner’s equity. In case the company earns less on the fixed charge funds when compared to their costs, the resultant deficit will decrease the return on owner’s equity. The rate of return on the owner’s equity is thus levered above or below the rate of return on total assets.

Thus a simple logic can be arrived at as under. If all other things remain same, lower the amount borrowed, lower the interest, lower will be the profit and greater the amount borrowed, lower the interest, greater will be the profit

Financial leverage reflects the amount of debt used in the capital structure of the firm. Because debt carries a fixed obligation of interest payments, we have the opportunity to greatly magnify our results at various levels of operations. The degree of financial leverage is computed as the percentage change in earnings available to common stockholders associated with a given percentage change in earnings before interest and taxes.

Thus financial leverage is a commitment to fixed debt charges payment obligation undertaken by a company.

The market value of equity in debt ratio and debt equity ratio is more appropriate, because market values normally reflect the current attitude of the investors, in normal markets.

If the shares of the company are not traded in the stock exchanges (or markets) or are not actively traded in the stock exchanges then it would be difficult to get correct information on market values. The debt ratio and debt equity ratio are also known as capital gearing ratios.

The degree of financial leverage (DFL) is defined as the percentage change in earnings per share [EPS] that results from a given percentage change in earnings before interest and taxes (EBIT), and it is calculated as follows:

This calculation produces an index number which if, for example, it is 1.43, this means that a 100 percent increase in EBIT would result in a 143 percent increase in earnings per share. (It makes no difference mathematically if return is calculated on a per share basis or on total equity, as in the solution of the equation EPS cancels out.)

When the economic conditions are good and the company’s Earnings before interest and tax are increasing, its EPS increases faster with debt in the capital structure. The degree of financial leverage is expressed as the percentage change in EPS due to a given percentage change in EBIT.

DFL = % change in EPS / % change in EBIT

An alternate formula to calculate the degree of financial leverage is as follows:

DFL = EBIT / (EBIT – Int) = EBIT/PBT = 1 + INT/PBT

Financial leverage on the one hand increases shareholders’ return and on the other, it also increases their risk. For a given level of EBIT,

Thus financial leverage is a double edged weapon. It may assure you a higher return but with a higher risk. Normally, a trade off between the return and risk will be arrived at to determine the appropriate amount of debt.

Let us examine this with an example

A company’s expected EBIT is Rs.150 with a standard deviation of Rs.50. This implies that the earnings could vary between Rs.100 and Rs.200 on an average. Suppose that the company has some debt on which it incurs Rs.50 as interest.

Now the shareholders’ expected earnings will be Rs.150 less Rs.50 = Rs.100 (taxes are ignored). Standard deviation will remain unchanged at Rs.50. Now the shareholders earnings will on an average vary within a range of Rs.50 and Rs.150. If EBIT is Rs.50, then the shareholders may not earn anything. If it is less than Rs.50, their earnings may be negative. In extreme situations if the company is unable to pay interest and principal on the debt borrowed, its very existence may be threatened by the insolvency proceedings that may be initiated by the creditors.

Tags : Financial Management - CAPITAL STRUCTURE THEORIES

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