Financial leverage is the type of debt that a business entity or a firm utilizes to purchase more assets in order to run business operations. A business entity utilizes financial leverage in the case when it is hesitant to invest equity capital into business investment. In simpler words financial leverage can be defined as the ratio of total debts to the total assets of a company. Companies utilize financial leverage to grow assets rather inviting more equity capital that can also results in reducing the earnings per share of the existing share holders of the company. There are two major advantages of financial leverage one is that it enhances earnings and the other is that it helps in getting a business entity favorable tax treatment.
Financial leverage may results in large amount of profit that may results in a negative effect on the stock price of the company as it becomes more volatile. The compensation expense associated with high volatile stock may create a problem for the business.
Consider the example of two business firms one of which is using financial leverage where as other one is running business on capital investment. Company ABC is running a manufacturing factory and used $1,000,000 to set up the factory. The entire amount is paid through capital investment and company has not incurred any debt to set up manufacturing unit. The unit is producing $150,000 profit per annum. On the other hand a company XYZ establishes a manufacturing unit by capital investment of $100,000 and a debt of $900,000. The unit is also producing the same profit of $150,000. That means the company XYZ is enjoying 150 percent profit on its capital investment. However if the company incurs loss the debt will be triple the amount of its original investment.
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