Financial leverage is the easiest way for shareholders to acquire huge returns. However, it also can also result in bankruptcy, especially when the cash flow falls way below the entity’s expectations. In this article, StoxMarket will help you understand what financial leverage is all about, how to measure it and the advantages of the same.
Financial Leverage Explained
Simply put, financial leverage is the debt amount used by an organization for purchasing additional assets. Leverage is used for avoiding the use of excessive operations for funding operations. According to StoxMarket experts, excessive financial leverage can increases the risk level of an entity, as the organization would face difficulty in paying debt.
Measuring Financial Leverage
In order to measure financial leverage of an entity, the traders need to measure the ratio of the total amount of debt as opposed to the total number of assets. The financial leverage amount of the company increases as and when the debt proportion increases in comparison to its assets. StoxMarket experts are of the opinion that most of the companies utilize financial leverage instead of acquiring additional equity investments as the later can minimize the earnings per share of all the existing investors/shareholders.
Advantages of Financial Leverage
According to the StoxMarket experts, there are two main advantages of financial leverage including increased Earnings and better taxation treatment. However, entities should also be aware of the fact that financial leverage can also result in disproportionate loss, as the interest expenses could end up overwhelming the entity that has borrowed the money resulting in a huge loss.
In fact, the loss can be massive when the rate of interest rises or when returns acquired through assets drop. The massive ups and downs in revenues is caused due to increased leverage amount, which in turn makes the stock prices of a company much more volatile. To sum up, financial leverage is acceptable in case of companies that achieve steady revenues and has huge reserves of cash as the conditions on which they operate are more or less steady. According to StoxMarket, no lender would want to lend excessive funds to an entity, which already has already taken huge amount of debt.