Measures of Financial Leverages Homework Help

Measures of Financial Leverages

Financial leverage measures the degree of the use of debt and other fixed-cost sources of fund to finance the assets the firm has acquired. As shown above, the use of debt has a magnifying effect on the earnings per share. It can be said that the higher the proportion of debt in the capital structure, the higher is the financial leverage and vice-versa. Broadly speaking, financial leverage can be measured in two ways: (i) stock terms, and (ii) flow terms

Stock Terms

It can be measured either by (a) a simple ratio of debt to equity, or (b) by the ratio of long-term debt plus preference share to total capitalization. Each of these measures indicates the relative proportion of the funds to the total funds of the firm on which it is to pay fixed financial charges.

Flow Terms

The financial leverage can be measured either by (a) the ratio of EBIT to interest payments or (b) the ratio of cash flows to interest payment, popularly called the debt service capacity/coverage. These coverage ratios are useful to the suppliers of the funds as they assess the degree of risk associated with lending to the firm

In general, the higher the stock ratios and the lower the flow ratios, the greater is the risk and vice-versa.

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