Financial leverage can be said to work as a two edged sword in one hand. It has unfavourable effects. One favourable effect is that level of performance (profit before tax) increases. while the unfavourable effect is that as more debt is employed in the firm. Such as the level of profit before tax is subjected to great variations and unpredictability. A relationship has been found to exist between the level of activity in the economy and the amount of debt employed, the amount of debt employed can either increase or decrease with a risk in economic activities. The extent of this occurring depends on the policies of the company. Also a relationship exist between the amount of debt employed and level of profit before tax. A third relationship also exists in that level of economic activity indirectly affects the performance of a company.
Degree Of Financial Leverage : The degree of financial leverage is defined as a ratio of the percentage charged in income available to common stock holder’s that is associated with a given percentage charged in earning before interest and tax.
Favourable Effect : This occurs when EPS increases due to the use of debt in capital structure. This is as a result of the rate of return on the company assets being more than the cost of capital
Unfavourable Effect : Unfavourable financial leverage occurs when EPS decrease because of the debt in the capital structures. Financial leverage has an effect in the tax payable. Bond interest is deducted before arriving at the net profit in which the tax rate is based. other effect of financial leverage is the fact that it increases the degree of fluctuation in the rate of return upon common stockholders investment.
From studies, it is observed that.
1. The performance of the economy affect the performance of a company.
2.Financial leverage increase or decrease the profitability of a firm depending on the way it is used and also to management abilities.
3. Financial leverage can be beneficial to a company in that as debt is employed more funds are made available for investment and as such profit tends to increase.
4. the use of debt increase the variability of the performance of the company.
Ratio analysis: involves the used of ratio as a yardstick for evaluating the financial position and performance of firms. three leverage ratio are:
a. Debt to assets ratio
b. Debt to equity ratio
c. Time interest earned ratio
Data required to carry out analysis are source from income statement of the firm and as follows:
i. TOTAL DEBT: This include all current liabilities and all type of long term debt. Infact, total debt refers to all financing that are outside equity financing.
ii. TOTAL ASSETS: This includes all current and fixed assets which the company own, these are the wealth of the company.
iii. Equity: This makes up the sum total of all the shareholders funds emcompass all resources and common stock equity before analysis is embarked upon
Base on findings the following recommendations can be out forth.
. Company should seek to employ financial managers who have foresight and are well groan studying the economy and the market in which the company operate.
. The economy and the sector in which a company operate should be watched diligently to know when more debt would be required by the firm and when the firm would need to reduce the amount of debt already employed.
. Leverage ratio should be moderate (not more than 50%) so that creditors would be willing to lend, if this is not so, then creditors would shy away from the company and so the firm will not be able to reap the benefits of financial leverage.
. Post performance of company should be studied and the use of the statistics to forecast future trends should be employed so that allowances would be made for future deviations since they have be forecasted before the actual occurrence.