IGNOU MCO 7 2017 2018 - What is financial leverage ? Examine the impact of financial leverage

Question

What is financial leverage ? Examine the impact of financial leverage on the EPS. Does the financial leverage always increase EPS? Explain.

23 Jan 2018

Answer :

Word Count : 787

Financial Leverage (FL) refers to usage of Debt in the capital structure. It is the use of fixed cost of capital (debt) in the total capitalization of the fir,. Fixed cost capital includes loans, debentures and preference share capital. It is also collect capital gearing.

It, also called “Trading on Equity”, is expressed as the firm’s ability to use fixed financial cost in such a manner so as to have magnifying impact on the EPS due to any change in EBIT (Earning Before Interest and Taxes). In other words, it is a process of using debt capital to increase the return on Equity.

A firm with high FL will have relatively high fixed financing costs compared to a firm with low FL.

According to Guthman, “It is the ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on the firms’s EPS.

The following are the Essential of FL:

It relates to liabilities side of balance sheet.
It is related to capital structure.
It is related to financial risk.
It affects earning after tax and

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