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What is Financial Leverage?
Financial leverage is used to buy more debt to buy more assets. However, an excessive amount of financial leverage increases the risk of failure, as it is more difficult to repay debt. Most of the companies have some level of financial leverage, however caution must be taken not to overdo it. In case of financial leverage, the beta value goes up with increased leverage which may point towards distress or issues with the financials.
What is the main advantage of financial leverage?
Corporate firms utilize financial leverage mainly to increase the company’s Earnings Per Share (EPS) and to increase its Return On Equity (ROE). However, these steps invite increased earnings variability and the chances of an increase in the cost of financial distress, perhaps even bankruptcy.
What does an increase in leverage mean?
When a company, property, or investment is considered as "highly leveraged," it means that the company has more debt than equity. Leverage is used to increase the returns palpably that can be gained from an investment.
How can leverage be reduced?
Leverage can be reduced by increasing the Revenue. It is the most logical step a company can take to reduce its debt-to-capital ratio. What it does is that it increases the sales revenues and thereby profits. This can be achieved by various means, such as increasing the sales, reducing the costs, or raising the prices. The extra cash generated by increased sales can then be used to pay off the existing debt.
What does financial leverage tell you?
The degree of financial leverage (DFL) takes into consideration the percentage change in EPS for a unit change in operating income. It is also called Earnings Before Interest and Taxes (EBIT). The ratio implies that, the higher the amount of financial leverage, the higher the beta would become.
How to know if financial leverage is positive or negative?
- In case of positive leverage, the investor borrows funds and then invests them at an interest rate higher than the rate at which they were borrowed.
- However, leverage can turn negative when the return on invested funds decreases, or if the interest rate on the borrowed funds goes up.
What are the pros and cons of financial leverage?
Following are some of the pros and cons of financial leverage −
- Borrowers may invest a relatively small upfront amount.
- Borrowers may purchase more assets via debt financing with the extra funds.
- Financial leverage can provide higher returns than other individual or business returns when the conditions are favorable.
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