Page 152 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes

Task Given-Financial leverage is 2
Fixed interest charge 1,00,000.

Find out the operating profit.

Significance of Financial Leverage
Financial leverage is a double-edged sword. On the one hand, it increases earnings per share,
and on the other hand it increases financial risk. A high financial leverage means high fixed
financial cost and high financial risks, i.e., as the debt component in capital structure increases,
the financial leverage increased and at the time of the financial risk also increases. i.e., risk of
insolvency increases.

!

Caution The finance manager is required to trade–off i.e., there has to be a balance between
risk and return for determining the appropriate amount of debt in the capital structure of
a firm.

Self Assessment

Fill in the blanks:
9. The financial leverage is favourable when the firm earns more on the investments/assets
financed by the sources having ………..charges.
10. As the ……….component in capital structure increases, the financial leverage increased.
11. A high financial leverage means high fixed financial cost and high financial…………..

8.4 Combined Leverage

Combined leverage or total leverage can be defined as potential use of fixed costs, both operating
and financial, to magnify the effect of changes in sales on the firms, earnings per share. Total
leverage or combined leverage can therefore be viewed as the total impact of the fixed cost in
the firms operating and financial structure.

Combined leverage = operating leverage × financial leverage
% change in EBIT % change in EPS
= ´
% change in sales % change in EBIT
% Change in EPS
=
% Change in Sales
Significance of Combined Leverage

A high operating leverage and a high financial leverage combination is very risky. If the company
is producing and selling at a high level it will make extremely high profit for its shareholders.
But, even a small fall in the level of operations would result in tremendous fall in earnings per
share. A company must, therefore, maintain a proper balance between these two leverages.

A combination of high operating level and a low financial leverage indicates that the management
is careful since the higher amount of risk involved in high operating leverage has been sought to be
balanced by low financial leverage. However, a more preferable option would be to have a low

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