Explain various financial ratios falling under the category of liquidity ratios.Explain the concept of financial leverage.
inancial leverage is the amount of debt that an entity uses to buy more assets. Leverage is employed to avoid using too much equity to fund operations. An excessive amount of financial leverage increases the risk of failure, since it becomes more difficult to repay debt.
The financial leverage formula is measured as the ratio of total debt to total assets. As the proportion of debt to assets increases, so too does the amount of financial leverage. Financial leverage is favorable when the uses to which debt can be put generate returns greater than the interest expense associated with the debt. Many companies use financial leverage rather than acquiring more equity capital, which could reduce the earnings per share of existing shareholders.
Financial leverage has two primary advantages:
- Enhanced earnings. Financial leverage may allow an entity to earn a disproportionate amount on its assets.
- Favorable
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