Financial leverage is one of the ways to increase the company`s profit: it means use of debt instruments to increase the expected level return on company`s equity. The level of the company`s financial leverage is estimated by the ratio of debt to the sum of debt and equity. The higher this ratio is, the more risky is the situation of the company. Together with that, there has been noticed the effect of financial leverage: the higher the level of leverage is, the more rises expected profit on company`s equity. Therefore, financial leverage can be used in different situations as a mechanism of changing the company`s financial position and cash flow.
There are 4 positions which are correlating with financial leverage level and dependable on it. They are:
1. The ratio of debt and equity, i.e. the cost of capital;
2. Influence of financial leverage on business cycle and production;
3. The whole leverage level within the company`s branch and industry; the correspondence between the middle leverage level and company`s current financial leverage ratio;
4. The compliance of company`s philosophy and mission with the situation connected with financial leverage ratio.
The effect of financial leverage can be used for stimulating profit and growth, but it is more likely for companies in the stage of birth and youth. The ratio of financial leverage is the figure contrary to stability and is proportional to the variability of profit; profits of companies with high leverage level vary more within the same conditions as profits of companies with lower leverage level.
One more position affected by leverage ratio is the flexibility of the company, its openness and dynamics concerning changes in technology, industry and possibilities. Companies with high leverage level have less flexible policy due to the fact they are responsible for their creditors and often have to fulfil some agreements and restrictions on their capital use and investments. In conditions of changing environment and the necessity of taking risky decisions companies with high leverage level are less successful; they may not use their expansion or growth opportunities.
Another risk of using leverage as an instrument of increasing profit is the fact that the difference between return on assets and the company`s debt remains positive, the company`s profits ratio to equity is high, but if the debts exceed the return amount, then the leverage effect disappears and the debts remain.
Therefore leverage level and its usage should be a matter of analysis of financial management. One of the ways to calculate the return of leverage upon return rate is to find the difference between interest rates on assets and debts, multiply this difference to the ratio of debt to equity, and add the expected return on assets.
As was mentioned above, a matter of analysis should also be the average leverage level in the industry, for example in manufacturing industry it equals to 0.25, and in utility industry this ratio is 1.3 – 1.4. Industries that are developing fast allow less leverage level than stably growing branches.
In general, financial leverage effect may be used for improving the company`s situation and profits, but it should be not accepted as an ideology and requires a detailed analysis of current situation and environment.
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