Relationship Between Financial Leverage and Risk

Not to be confused with operating leverage, financial leverage involves the use of debt in the firm’s financial structure. Though it may be operationally defined and measured in a variety of ways, it essentially entails the use of debt to extend the earning power of funds committed by the firm’s shareholders. When used properly financial leverage magnifies returns on committed funds.

Because of the nature of financial leverage, it carries within it not only the general types of risk associated with operating leverage, but also two others that have rather specific implications. First, there is the risk of default-the inability to meet debt obligations as they come due. By definition, as financial leverage increases, cash flow requirements necessary to service additional debt increase as well. The risk of inadequate cash flow is, therefore, a primary concern in strategic decisions regarding financial structure. This, of course, suggests that liquidity and leverage are intricately intertwined in decisions of that kind.

Second, the informed strategist not only must consider the risk of default and the involuntary actions that failure may lead to, but also the priority of claims that attend a given financial structure. In the case of liquidation, voluntary or involuntary, shareholders normally hold a claims position subordinate to that of debt holders. Thus increased leverage can have a deteriorating effect on the assets available for distribution to shareholders upon liquidation. Therefore, this component of risk enters financial structure decisions as well.

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