FINANCIAL LEVERAGE - Accounts and Finance for Managers

The next leverage is Financial Leverage which arises due to servicing of financial resources.

  • It results from the presence of fixed financial charges in the firms. The fixed financial charges are nothing but the preference dividend and interest on the fixed charge financial resources.
  • Financial leverage, how the fixed charge financial resources influence the EBIT of the firm and finally provides earnings to the shareholders. It reveals the ability of the firm to make use of "fixed financial charges to magnify the effects of changes in EBIT on the earnings per share".

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.

  • The financial manager of the hypothetical ltd expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs.10,000. The firm has 5 percent bonds aggregating Rs.40,000 while the 10 percent preference shares amount to Rs. 20,000 what should be the earnings per share (EPS)?Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected ? The firm tax bracket 35%. Ordinary number of shares 1,000

FINANCIAL LEVERAGE

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 (Base)=
EBIT
EBIT–I–Dp/1–t


DFL of the above firm is as follows:

DFL=
% change in EPS
% change in EBIT
=
81.25%
40%
=2.03125


Alternately, the DFL is computed as follows through the following methodology

DFL=
Rs. 10,000
Rs10,000 – Rs.2,000–Rs.2,000/.65
=2.03125


The same example drawn for our better understanding by excluding the fixed charge of financial resources.

FINANCIAL LEVERAGE

Degree of FINANCIAL LEVERAGE

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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