The use of fixed-charges sources of funds, such as debt and preference capital along with owner’s equity in the capital structure described as financial leverage gearing or trading on equity. The use of the term trading on equity is derived from the fact that is the owner’s equity that is used to raise debt; that is, the equity that is traded upon.
Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effect of change in E.B.I.T on the firm’s earning per share. The financial leverage occurs when a firm’s Capital Structure contain obligation of fixed financial charges. For instance, interest on debentures, dividend on preference share etc., along with owner’s equity to enhance earning of equity shareholder’s. The fixed financial charges do not vary with the operating profit. They are fixed and are to be paid irrespective of level of operating profit. The ordinary shareholders of firm are entitled to residual income i.e. earning after fixed financial charges.
The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owner’s equity. The rate of return on the owner’s equity is levered above or below the rate of return on the owner’s equity.
Favorable and Unfavorable Financial Leverage
Financial leverage may be favorable or unfavorable depending upon whether the earning made by the use of fixed interest or dividend bearing securities exceeds the explicit fixed cost, the firm has to pay for the employment of such funds or not. The leverage will be considered to be favorable so long the firm earns more on assets purchased with the funds than the fixed cost of their use. Unfavorable leverage occurs when the firm does not earn as the funds cost.
Significance of Financial Leverage
Financial leverage helps in deciding the appropriate Capital Structure. One of the objectives of planning an appropriate Capital Structure is to maximize the return on equity shareholders funds or maximize the earning per share.
Financial leverage is double-edged sword. On one hand, it increases the earning per share and on the other hand it increases the financial risks. High financial leverage means high fixed financial cost and high financial risk i.e., as the debt content in Capital Structure increases, the financial leverage increases and at the same time the financial risk also increases i.e., risk of insolvency increases. The finance manager is required to trade-off between risk and return for determining the appropriate amount of debt.