financial leverage

What is financial leverage according to Taxmann?

The term leverage is defined as the relationship between two interrelated variables. In a business firm, these variables may be the costs, output, sales revenue, earnings before interest and taxes (EBIT), Earnings Per Share (EPS) etc.

In terms of financial management analysis, Leverage represents the influence of one financial variable over another. It also helps to understand the relationship between any two given variables.

During leverage analysis, the primary focus is on measuring the relationship between any two variables rather than measuring these variables individually.
However, for the two variables to be eligible for a leverage study, both should be interrelated; otherwise, the study will prove unfruitful.

 

Leverage is the per cent change in one variable divided by the per cent change in some other variable or variables. Therefore, if put in an equation, the numerator is the dependent variable, and the denominator is the independent variable. Thus, the primary goal of Leverage Analysis is to reflect how responsive is the dependent variable to a change in the independent variable.

Algebraically, the Leverage may be demonstrated as:

 

Leverage          = % Change in Dependent Variable  
% Change in Independent Variable

 

For any given firm, the EBIT is subject to many influences. Some of them might be particular to a firm, and others might be common to all the firms in the industry or the general economic conditions that affect them.

 

In a practical situation, the EBIT may vary and give unexpected results in any period. This uncertainty attached to EBIT is generally referred to as business or operational risk. Business fluctuations and, in particular, the possibility of an economic recession are some of the primary sources of operating risks. Irrespective of the amount of EBIT earned, a fixed amount of interest must be paid to the debt investors. Consequently, the residual profit available to shareholders also varies in response to changes in EBIT.

 

A significant portion of EBIT decline is ultimately deducted from the earnings going to the equity shareholders. As a result, the more debt financing is used, the more sensitized the earnings going to equity shareholders to a change in EBIT. The relationship between the debt financing in the capital structure and its effect on the earnings available to the equity shareholders can be analyzed using the Operating Leverage and FinancialLeverage.

 

Operating Leverage is the relationship between sales revenue and EBIT, whereas the relationship between EBIT and EPS is defined as financial Leverage.

 

The Financial Leverage (FL) measures the relationship between the EBIT and the EPS and represents the effect of change in EBIT on the level of EPS. The FL measures the responsiveness of the EPS to a change in EBIT and is defined as the % change in EPS divided by the % change in EBIT. Symbolically,

Financial Leverage = % Change in EPS  
% Change in EBIT
= Increase in EPS ÷ EPS
Increase in EBIT ÷ EBIT

 

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