What Is Financial Leverage

Financial leverage is a way for achieving bigger results with relatively small amount of capital/financial resouces. This is usually possible with the help of credit, but leverage could also be achieved with the help of some financial instruments like derivatives. In the most common case, borrowing against the initial amount of capital is what actually leverage is. This way one increases the power of his money, adding some more on credit secured by the money. It is used everywhere in the financial world and its main purpose is greater financial result. Sometimes all of this is also referred as gearing. A majority of businesses use financial leverage to borrow money, providing part of the total capital needed for their assets. The main reason for debt is to close the gap between how much capital the owners can come up with and the amount the business needs. Lenders are willing to provide the capital because they have a senior claim on the assets of the business. Debt has to be paid back before the owners can get their money out of the business. A businesss owners equity provides a relatively permanent base of capital and gives its lenders a cushion of protection. The degree of financial leverage is earnings before interest and taxes, divided by earnings before taxes. The formula is: Earnings before interest and taxes / Earnings before taxes The degree of financial leverage calculates the proportional change in net income that is caused by a change in the capital structure of a business to either increase or decrease the amount of debt. This measurement can also be used to model the proportional change in net income caused by a change in the interest rate (even if the amount of debt remains the same). The degree of financial leverage is useful for modeling what may happen to the net income of a business in the future, based on changes in its operating income, interest rates, and/or amount of debt burden. In particular, when debt is added to a business, this introduces interest expense, which is a fixed cost. Since interest cost is a fixed cost, it increases the breakeven point at which a business begins to turn a profit. The result is usually a higher level of risk, where a company can earn a great deal more money above its breakeven level, but the higher breakeven level also means that the company will lose more money if sales dip below the higher breakeven level. The metric can also be used to compare the results of several businesses to see which ones have more financial risk built into their capital structures. This information might lead an investor to buy the shares of a company with a higher degree of financial risk during an expanding economy, since he should earn outsized profits on higher sales volume. Conversely, the same information would lead an investor to buy the shares of a company with a lower degree of financial risk during a contracting economy, since its lower breakeven point should mitigate its losses. Thus, this type of analysis can be used to compare and contrast the likely financial performance of companies within a single industry, and reapportion investments among them, depending on the economic environment.