Financial Leverage and Risk

If increased financial leverage leads to increased return on equity, why do companies not resort to ever increasing amounts of debt financing? Why do financial and other term lending institutions insist on norms for debt-equity ratio? The answer is that as the company becomes more financially leveraged, it becomes riskier, i.e., increased use of debt financing will lead to increased financial risk which leads to increased fluctuations in the return on equity and increase in the interest rate on debts.

Financial Leverage-Effect on the Shareholders’ Return

The primary motive of a company in using financial leverage is to magnify the shareholders return under economic conditions. The role of financial leverage in magnifying the return of the shareholders is based on the assumptions that the fixed charges can be obtained at a cost lower than the firm’s rate of return on net assets. Thus, when the difference between the earnings generated by assets financed by the fixed-charges funds and costs of these funds is distributed to the shareholders.. The EPS or ROE increases. However, EPS or ROE will fall if the company obtains the fixed-charges funds at a cost higher than the rate of return on the firm’s assets. It should, therefore, be clear that EPS, ROE and ROI are the important figure for analyzing the impact of financial leverage.