Definition of Financial leverage
Businesses run on capital. There are two main methods to inject capital in the business; equity and Debt.
Brief Explanation of Financial leverage
Equity means borrowing money from shareholders and in return give them the profit share on periodic basis called dividends. Company is not liable to pay dividends to its shareholders on compulsory basis. In fact, it’s their own decision whether to reinvest the profit or to distribute a portion among the shareholders. Such shares are called regular shares. However, in preference shares company has to pay its shareholders dividend and these are called preference shareholders. Preference shareholders do not have voting right in Annual General Meeting then.
Debt on other hand is borrowing money in the form of loan from financial institutions and banks and in return pay them a fixed amount of interest periodically. This type of lenders have no right to interfere in business decisions and its activities.
Financial leverage is the use of debt financing in acquiring an asset or segment of business or to increase sales or product volume etc.
Capital is injected in business from both resources equity and debt in an appropriate blend or ratio because both financing have their pros and cons.
- The more debt financing is used by a business the higher the financial leverage.
- The higher the financial leverage the higher the periodic interest to be paid.
- The high financial leverage means regular shareholders risk of receiving their dividend shares as debt is paid on priority.
- Also during the liquidation of the business debts and preference shareholders are treated on priority.
- Financial leverage is calculated by the following formula
- Financial leverage = (Total Debts)/ (Total capital or Debt Equity)
- If the ratio is 1 means, there is a balanced proportion of debt and equity capital in the business.
- Above 1 is an alarming factor.
Lower to 1 means company is more financially stable