Leverage activities with financing activities is called financial leverage. Financial leverage
represents the relationship between the company’s earnings before interest and taxes (EBIT)
or operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share”. It involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the shareholders.
“The use of long-term fixed interest bearing debt and preference share capital along with
share capital is called financial leverage or trading on equity”.
Financial leverage may be favourable or unfavourable depends upon the use of fixed
Favourable financial leverage occurs when the company earns more on the assets
purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive
Unfavourable financial leverage occurs when the company does not earn as much as
the funds cost. Hence, it is also called as negative financial leverage.
Financial leverage measures the percentage of change in taxable income to the percentage
change in EBIT.
Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
Financial leverage is one of the important devices which is used to measure the fixed
cost proportion with the total capital of the company.
If the firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease.