Page 171 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes It is seen that in:
Case No. I – A 40% increase in EBIT has resulted in a 100% increase in earnings per share (from
2.40 to 4.80).

Case No. II – A 40% decrease in EBIT has results in a 100% decrease in earning per share (from
2.40 to 0).

i.e., financial leverage is: = 2.5

The effect of financial leverage is such that an increase in the firm’s EBIT results in a more than
proportional increase in the firms earnings per share, whereas a decrease in the firms EBIT
results in a more than proportional decrease in EPS.

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 ……………. .

7.4 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.

=  =

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