key term - Financial leverage

Definition

Financial leverage refers to the use of borrowed funds to increase the potential return on investment. By using debt, companies can amplify their earnings, but it also increases the risk because if the investment does not perform well, the losses are also magnified. This concept is essential when evaluating a company's earnings per share, as higher financial leverage can lead to higher earnings per share if the company performs well.

5 Must Know Facts For Your Next Test

1. Financial leverage can enhance earnings per share (EPS) when investments funded by debt generate returns greater than the interest costs on that debt.
2. While financial leverage can increase potential returns, it also raises the risk of bankruptcy if a company cannot meet its debt obligations.
3. Companies with high financial leverage may experience more significant fluctuations in their EPS, making their stock more volatile.
4. Investors often scrutinize a company's financial leverage when assessing its risk profile and potential for growth.
5. Strategic use of financial leverage is critical for companies aiming for aggressive expansion, but it must be balanced against the risks involved.

Review Questions

• How does financial leverage impact a company's earnings per share?
  • Financial leverage can significantly impact a company's earnings per share (EPS) by magnifying returns when the company earns more than it pays in interest on its debt. If a company successfully invests borrowed funds into profitable projects, the additional earnings contribute directly to increased EPS. However, if the investments do not yield sufficient returns, the losses are equally amplified, making it essential for management to carefully evaluate the risks associated with high financial leverage.
• Evaluate the risks associated with using financial leverage in business operations.
  • Using financial leverage carries several risks, including increased volatility in earnings and potential difficulty in meeting debt obligations. A company with high levels of debt may struggle during economic downturns or periods of low revenue, leading to significant financial strain. Moreover, creditors may impose stricter terms or may be less willing to lend further capital if they perceive high risk from elevated leverage levels, which could stifle growth opportunities.
• Analyze how a company's decision to increase its financial leverage might influence investor perceptions and market performance.
  • When a company decides to increase its financial leverage, it can lead to mixed perceptions among investors. On one hand, higher leverage may signal confidence in future growth prospects and the potential for enhanced earnings per share, attracting investors looking for aggressive growth opportunities. On the other hand, increased leverage raises concerns about financial stability and risk exposure. Investors may react by adjusting their valuation of the stock based on perceived risk versus reward, potentially affecting market performance and stock prices.

Related terms

Debt-to-Equity Ratio:

A financial ratio that indicates the relative proportion of shareholders' equity and debt used to finance a company's assets.

Return on Equity (ROE): A measure of financial performance calculated by dividing net income by shareholders' equity, reflecting how effectively management is using a company’s assets to create profits.

Operating Leverage: The degree to which a company uses fixed costs in its operations; high operating leverage means that a small change in sales can lead to a large change in profits.