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What Is Financial Leverage

FINANCIAL LEVERAGE DEFINITION AND MEANING

Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.

Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.

“The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity”.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds.

finance
[Post Image Courtesy of SSCreations at FreeDigitalPhotos.net]

Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Financial leverage can be calculated with the help of the following formula:

FL = OP / PBT

Where,

FL = Financial leverage

OP = Operating profit (EBIT)

PBT = Profit before tax.

About Author Mohamed Abu 'l-Gharaniq

when an unknown printer took a galley of type and scrambled it to make a type specimen book. It has survived not only five centuries.

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