Understanding Financial Leverage and Its Implications
Financial leverage refers to a firm's ability to use fixed financial costs to amplify the impact of changes in earnings before interest and tax on its earnings per share. It involves concepts like EBIT, EBT, preference dividends, and tax rates, and can be measured through the degree of financial leverage. The characteristics of financial leverage highlight its relationship to the liabilities side of the balance sheet, the mix of financing methods, and the financial risk involved. Combined leverage, a combination of operating and financial leverage, further affects the firm's profitability. Degree of combined leverage measures the percentage change in earnings per share due to changes in sales, providing insights into the firm's financial performance.
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Presentation Transcript
Meaning of Financial Leverage Meaning of Financial Leverage The firm s ability to use fixed financial charges/costs to magnify the effect of changes in earnings before interest & tax (EBIT) on firm's earning per share. It sometimes treated as "Trading on Equity".
Financial Leverage =EBIT EBIT EBTor EBT (PD 1 t) *EBIT = Earning before Interest & Tax *EBT = Earning before tax *PD = Preference dividend *t = Tax rate
Degree of Financial Leverage Degree of Financial Leverage The DFL can be measured in any of two ways:- % Change in EPS % Change in EBIT DFL =
Characteristics of Financial Characteristics of Financial Leverage Leverage It is related to liabilities side of balance sheet. It is the mix of methods of financing. It shows effect of changes in operating profits on earnings per share due to fixed financial charges. It involves financial risk.
Meaning of Combined Leverage Meaning of Combined Leverage The combine leverage may be defined as the relationship between contribution and the taxable income. Combined Leverage = Operating Leverage x Financial Leverage Or Contribution EBIT EBIT EBT
Degree of Combined Leverage Degree of Combined Leverage DCL measures the percentage change in earnings per share due to percentage change in sales. DCL= DOL DFL Or % Change in EBIT % Change in Sales % Change in EPS % Change in EBIT Or % Change in EPS % Change in Sales
