CAIIB · ABFM

FINANCIAL LEVERAGE OR TRADING ON EQUITY

Chapter notes, video classes, MCQ practice tests and quick-revision one-liners for Advanced Business and Financial Management — CAIIB.

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What is financial leverage?

Financial leverage refers to the use of fixed-cost debt financing to magnify the returns available to equity shareholders, also known as trading on equity.

What is the primary objective of using financial leverage in a firm?

To magnify returns to equity shareholders using borrowed funds.

What does the term 'trading on equity' mean?

Trading on equity means using borrowed funds at a fixed rate of interest to earn a higher return on equity, thereby increasing earnings per share for shareholders.

What does 'trading on equity' specifically refer to?

Using debt capital to earn more than its interest cost.

How is the Degree of Financial Leverage (DFL) calculated?

DFL is calculated as EBIT divided by EBT (Earnings Before Interest and Taxes divided by Earnings Before Tax), or equivalently as percentage change in EPS divided by percentage change in EBIT.

Which ratio directly measures the extent of financial leverage in a firm?

Debt-to-equity ratio measures financial leverage extent.

What is the relationship between financial leverage and financial risk?

Higher financial leverage increases financial risk because fixed interest obligations must be met regardless of operating performance, magnifying both gains and losses for equity holders.

What happens to EPS when EBIT falls and financial leverage is high?

EPS falls more sharply than the decline in EBIT.

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