Basic introduction to financial leverage

Financial leverage entails using fixed-cost financing, which is a choice of the firm seeking financing. For instance, a firm can finance operations and capital expenses using internal sources and common stock. It eventually escalates the return to the firm’s common shareholders. Financial leverage can be positive or negative depending on the outcomes. Negative leverage implies that the firm does not earn as much as fixed financing costs (Vithessonthi & Tongurai, 2015). If a firm earns more than the fixed financing costs by using funds obtained at a fixed cost, the leverage is favorable. Profits after meeting the fixed financing costs goes to shareholders.

For businesses with insufficient taxable income to shield, financial leverage lessens the equity value, eventually hurting the brand. In industries such as retail stores and grocery stores, companies operate with a considerably high degree of financial leverage. Nonetheless, it is crucial to understand the EBIT-EPS break-even analysis, the degree of financial leverage, the financial risk, and the degree of total leverage. The degree of financial leverage is the percentage of EPS that results from a given percentage change in EBIT (Besley & Brigham, 2019). To calculate this value, the percentage change in EPS is divided by the percentage change in earnings before interest and taxes (EBIT).

The EBIT-EPS analysis examines financial leverage impact on earnings per share under alternative financial plans. It is preferred in choosing a combination of various finance sources, helping select the alternative that yields the highest earnings per share. A significant benefit of this analysis is financial planning, whereby the firm evaluates alternatives to find the level of EBIT that maximizes earnings per share. It also helps in performance evaluation and determining the appropriate blend of debt and equity.

References

Besley, S., & Brigham, E. F. (2019). CFIN6: corporate finance. Cengage.

Vithessonthi, C., & Tongurai, J. (2015). The effect of firm size on the leverage–performance relationship during the financial crisis of 2007–2009. Journal of Multinational Financial Management, 29, 1–29. https://doi.org/10.1016/j.mulfin.2014.11.001