What is leverage financing in special financing?

The main objective of leverage is the maximisation of wealth of the shareholders. Financial leverage refers to buying the additional assets which company uses as its debt. The more the debt, more the leverage of that company.

However, more leverage will increase risk of failure. It is also called as trading on equity. Financial leverage represents left hand side of balance sheet.

  • Increase value of asset shows gain in owner’s cash.
  • Decrease value of asset shows loss in owner’s cash.

Measure of financial ratios are as follows −

  • Debt ratio = (debt/total assets)
  • Debt ratio = (debt/total assets)
  • Interest coverage ratio = (profits/interest)

Degree of financial leverage

Degree of financial leverage = (change in percentage of EPS/ change in percentage in EBIT)

EPS = Earnings per share, EBIT = Earnings before interests and tax

Steps in calculating financial leverage are as follows −

  • Calculate the total debt of the company.
  • Total number of equity shareholders.
  • Divide debt to equity shareholders.

Some of advantages are as follows −

  • Ideal/suits for acquisitions.
  • Ideal/suits for management buyouts.
  • Access to capital.

Some of the disadvantages are as follows −

  • Complexity.
  • Costlier.
  • Magnifies risk.