What is Financial Leverage? How does it calculate?

Financial Leverage: Financing additional assets through debt is known as Financial Leverage. If interest is higher than earnings is known as unfavourable finance leverage or if interest is less than earnings are known as favourable finance leverage. It helps to maximise the shareholders earning per share.It measure the financial risk in a company. Higher the fixed financial charges higher the degree of financial leverage.

Advantages of Financial Leverage:

·         It is easy for a company to raise further capital.

·         It fulfil the specific need of a company like acquisition, modernisation.

·         It increases the return on small investment.

Disadvantages of Financial Leverage:

·         It increases the burden of debt on a company.

·         Company have to pay more interest on that debt amount.

Formula:

DFL= EBIT/EBT

Where,

DFL = Degree of financial leverage

EBIT = Earnings before interest and tax

EBT = Earnings before tax

Example: Find out the financial leverage from the following information:

Particular	Amount (Rs.)
Sales	3,7,0,000
Fixed cost	90,000
Variable cost	1,20,000
Interest	45,000
Tax @40%	On profit

Solution:

Particular	Amount (Rs.)
Sales	3,7,0,000
Less: Variable cost	(1,20,000)
Contribution margin	2,50,000
Less: Fixed cost	(90,000)
EBIT	1,60,000
Less: Interest	(45,000)
EBT	1,15,000

Degree of Financial Leverage = EBIT/EBT

= 1, 60,000/1, 15,000

= 1.39

Example: Company wants to invest in some new projects for that Rs.300, 000 needed. Company has already issued shares of Rs.5, 00,000 of Rs.100 each and earnings before interest and tax is Rs.1, 20,000 issuing further shares means losing power to control the management of company. So, that’s why company has only one option to raise money through debenture @ 10%. You have to find out that investing in new projects through debt is right decision for the company or not if tax is 40%?

Solution:

Particulars	Debenture issue of Rs.3,00,000 and shares of   Rs.5,00,000 Amount (Rs.)	Share issue of Rs.8,00,000 Amount (Rs.)
EBIT	1,20,000	1,20,000
Less: Interest	(30,000)	-
EBT	90,000	1,20,000
Less: tax	(36,000)	(48,000)
Shareholders Profit	54,000	72,000
Number of shares	5000	8000
EPS	10.8	9
Financial leverage	1.33	1

Interpretation: Financing new project through debt increases earnings per share with the help of financial leverage (1.33) which is the main motive of every company. So, the decision is good for the company.   

Example: Company X wants to expand its business in different cities to satisfy more customer through their product. But company doesn’t have money for expansion purpose. So, the company decided to take a loan of Rs. 20, 00, 000 @ 9% per annum. Find out how much affect additional loan on  shareholders  earnings. Following information does not consider loan amount.

Particulars	Amount (Rs.)
Earnings  before interest and tax	42, 50,960
Interest	-------
tax	35%
Number of shareholders	1, 000

      Tax rate is same after taking a loan.

Solution:

Particulars	Amount (Rs.)	Amount (Rs.)
Earnings  before interest and tax (A)	42, 50,960	42, 50,960
Less: Interest	-------	3, 82,586
Earnings before tax (B)	42, 50,960	38, 68,374
Less: tax @ 35%	14, 87,836	13, 53,931
Earnings after interest and tax (C)	27, 63,124	25, 14,443
Number of shareholders ( D)	2, 000	2, 000
Degree of financial leverage (A / B)	1	1.10
Earnings per share (C / D )	1, 382	1, 257

The degree of financial leverage increases by 0.10% which means company has a liability to pay interest on loan. In that case the shareholders return are reduce due to that their EPS also reduces from Rs. 1, 382 to 1, 257.