The next leverage is Financial Leverage which arises due to servicing of financial resources.
The other name of the financial leverage is Trading on Equity, which illustrates the relationship in between the application of the fixed charge of funds in the capital structure and Earning per share. It is the leverage analysis highlights the relationship in between the financing decision and investment decision.
The fixed financial charge should pave way for the firm to not only to earn the greater EBIT but also to magnify the EPS of the shareholders.
From the above illustration, 40% increase in the level of EBIT posed 81.25% increase in the EPS and vice versa.
Financial leverage can be quantified through the Degree of Financial Leverage (DFL)
The degree of financial leverage is defined as the ratio of % change in the EPS and % change in the EBIT. Which always greater than 1. The degree of financial leverage is more than one due to presence of fixed charge of financial resources. This profound relationship is algebraically proven and illustrated that
DFL of the above firm is as follows:
Alternately, the DFL is computed as follows through the following methodology
The same example drawn for our better understanding by excluding the fixed charge of financial resources.
It means that the higher Degree of financial leverage means that greater the financial risk of the firm and vice versa. The greater degree of financial leverage is favorable only during the greater volume of EBIT to meet the fixed charges unless otherwise, the firm is required to undergo for liquidation. The interest of the firm may be brought under the control of the debenture holders and preference shareholders.
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