Saturday, January 8, 2011


Meaning of Financial Leverage

As stated earlier, a company can finance its investments by debt and equity. The company may also use preference capital. The rate of interest on debt is fixed irrespective of the company's rate of return on assets. The company has a legal binding to pay interest on debt. The rate of preference dividend is also fixed; but preference dividends are paid when the company earns profits. The ordinary shareholders are entitled to the residual income. That is, earnings after interest and taxes (less preference dividends) belong to them. The rate of the equity dividend is not fixed and depends on the dividend policy of a company.

The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners' equity in the capital structure, is described as financial leverage or gearing or trading on equity. The use of the term trading on equity is derived from the fact that it is the owner's equity that it is used as a basis to raise debt ; that is, the equity that is traded upon. The supplier of the debt has limited participation in the company's profit and, therefore, he will insist on protection in earnings and protection in values represented by ownership equity.

The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus or deficit will increase or decrease the return on the owners' equity. The rate of return on the owners' equity is leverage above or below the rate of return on total assets. For example, if a company borrows 100$ at 8% interest and invests it to earn 12% return, the balance of 4% after payment of interest will belong to the shareholders, and it constitutes the profit from financial leverage. On the other hand, if the company could earn only a return of 6% on 100$, the loss to the shareholders would be 2$ per annul. Thus, financial leverage at once provides the potentials of increasing the shareholders' earnings as well as creating the risks of loss to them. It is a double-edged sword. The following statement very well summarises the concept of financial leverage.

The role of financial leverage suggests a lesson in physics, and there might be some point in considering the rate of interest paid as the fulcrum used in applying forces through leverage. At least it suggests consideration of pertinent variables; the lower the interest rate, the greater will be the profit, and the less the chance of loss; the less amount borrowed the lower will be the profit or loss; also, the greater the borrowing, the greater the risk of unprofitable leverage and the greater the chance of gain.