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- To Indicate the reliability of a business on its debts in order to operate
- To determine financial solvency and its dependency upon its borrowings
A company’s capital structure consists of the debt and equity it uses to finance operations and growth. Leverage refers to the debt portion of capital and is usually expressed as total debt divided by owners’ equity. Some amount of leverage can increase the profitability of a company by providing funds for profitable investments. However, having too much debt can be risky.
A firm finances its assets /operations through some combination of equity and debt. Financial leverage is the extent to which a business is using the borrowed money to finance its assets and operations.
It is measured as the ratio of debt to debt plus equity. The greater the amount of debt, the greater the financial leverage.
The borrowed money is used to increase production volume, and thus sales and earnings.
Financial leverage helps in designing the appropriate capital structure. One of the objectives of planning an appropriate capital structure is to maximize return on equity shareholders' funds or maximize EPS.
Financial leverage is caused by a higher degree of financial obligations with fixed interest cost i.e., debts and preferred equity etc.
Financial Leverage ratios measure the extent to which a company utilizes debt to finance growth.
There are4 main Financial Leverage that we calculate.
1. Debt - Equity Ratio = Total Debt / Shareholders Equity
2. Debt Service Coverage Ratio = (PAT+ Interest Exp)/Principal Repayment+Interest Exp
3. Cash Coverage Ratio = (EBIT + Non Cash Expenses)/Interest Expense
4. Total Debt Ratio = Total Debt / Total Asset
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