Explain Financial Leverage. How is it calculated? What does high/ low financial leverage indicate?

Explain Financial Leverage. How is it calculated? What does high/ low financial leverage indicate?

Financial leverage is the leverage in which a company decides to finance majority of its assets by taking on debt. The leverages have been applied by investors and companies to generate more returns on their assets. This employment of leverage doesn't guarantee success and increases the possibility of excessive losses which becomes more great in high leverage positions. Firms use this leverage when they are unable to raise enough capital by issuing shares in the market and unable to meet their business needs. When firm takes on debt it sees that at that time how is the return on assets and for a firm it should be higher than the interest on the loan.

How is it calculated?

The calculation of financial leverage takes place in following steps:-

1) Calculation of total debt is carried out by the company which includes short term debt as well as long term debt.

2) Calculation of total equity takes place in the company by shareholders to find out the equity they multiply number of outstanding shares by stock price. This amount is represented as shareholder equity.

3) To calculate financial leverage ratio divide total debt with total equity.

4) If company has high financial leverage ratio than it could be a sign of financial weakness. This can also lead to bankruptcy if the company is highly leveraged.

What does high/ low financial leverage indicate?

High financial leverage indicates the risky investment made by the company's shareholders. Low financial leverage indicates that management has adopted a very good approach towards the debt capital. This decreases the management decision making on earning per share.

What does financial leverage indicate? What are its limitations?

Financial leverage indicates borrow of funds to raise the capital by issuing shares in the market to meet their business requirements. This also indicates the profitability and return on equity of the company which has taken significant amounts of debt. The financial leverage has many advantages but it possess some limitations as well which has been shown as follows:-

1) When a company borrows funds using financial leverage then this money develops an environment that can either creates lots of profits or a small amount of it.

2) Borrowing constantly creates an image that the company might be on high risk. Which in turn increases the interest rates and some restrictions could be handed over to the borrowing organization.

3) Value of stock also gets affected as it can drop substantially if the stockholders intervene in between.