What is financial leverage?

Till now we have come to know about many ratios to understand the financial condition of the company. Similarly, in this article we will know about another Ratio called Financial Leverage.

Meaning

Financial leverage means to increase the earnings of the companies by taking fixed interest loans.

For example, if the investor has invested 10 thousand rupees in a company, and by using it, the company earned 1000 rupees.

In this case, the company's earnings will be 10 per cent. If the same investor had invested Rs 5000 in the same company and if the remaining Rs 5000 would have been a loan and even then the company would have earned only Rs 1000, then its earnings would have been 20 per cent of the investment.

The company has increased the returns for the investors as it took loans. In the first situation the investor got 10 per cent return, while in the second position the investor got 20 per cent return. This is called Financial Leverage.

Most of the companies use this method to increase their and investors' returns which is not wrong.

But financial leverage is useful only as long as the company earns more profit than the interest it pays for the loan. After that, Financial Leverage is harmful for the company because no matter how much money the company makes money or not, it still has to pay interest. And if in any case the company makes less profit than the interest payable, it will not be able to pay the interest due to which the company will get into trouble because once the news of such happening spread in the market, the share price of the company may fall.

In such a situation, investors investing in that company may suffer losses. Therefore, for an investor, it is very important for us to understand Financial Leverage.

Formula to calculate with an example

Leverage = total company debt/shareholder's equity

Types of Leverage:

Operating: Operating leverage refers to the percentage of fixed costs with the company. In simple terms, operating leverage is the ratio of fixed costs to variable costs.

Financial: This also known as financial leverage or the use of debt, to operate a firm. This can improve the firm's return on equity and earnings per share. This is because the firm is not reducing earnings by using equity financing.

Capital: It means the ratio of current liabilities to working capital.

Working Capital Leverage: It refers to the impact of level of working capital on company's profitability.

Also watch:Difference between Simple and Compound Interest

Also watch: