Financial leverage is defined as the firm’s ability to use fixed financial charges to magnify the effect of change in EBIT (earnings before share). The fixed charges do not vary with the firm’s earnings before interest and taxes. Financial leverage indicates the effect on earnings creates by the use of fixed charge securities in the capitalization plan. It results from the use of funds with the fixed rate of return i.e., degree of financial leverage at any level of operation profit is :
Operating Profit (OP or EBIT)/EBIT – Interest (PBT)
(EBIT = Earnings before interest and tax)
(PBT – Profits before tax).
Financial leverage involves the use of funds at a fixed cost in the hope of increasing return to equity shareholders. The favorability of financial leverage of trading equity as it is called is judged in terms of the effect upon earning per share to equity shareholders.
Whether the leverage is favorable in the sense of increasing earnings per share, will depend upon the profitability of investment opportunities for which funds are used. If the rate of return on the investment these funds their explicit cost, leverage is said to be favorable in a narrow and restricted sense because it does not take into account any implicit cost inherent in the use of debt financing.