PPT - Financial Leverage | Accountancy and Financial Management - B Com PDF Download

 Page 1


FINANCIAL AND 
OPERATING 
LEVERAGE
Page 2


FINANCIAL AND 
OPERATING 
LEVERAGE
LEARNING OBJECTIVES
Explain the concept of financial leverage
 Discuss the alternative measures of financial 
leverage
 Understand the risk and return implications 
of financial leverage
 Analyze the combined effect of financial and 
operating leverage
 Highlight the difference between operating 
risk and financial risk
2
Page 3


FINANCIAL AND 
OPERATING 
LEVERAGE
LEARNING OBJECTIVES
Explain the concept of financial leverage
 Discuss the alternative measures of financial 
leverage
 Understand the risk and return implications 
of financial leverage
 Analyze the combined effect of financial and 
operating leverage
 Highlight the difference between operating 
risk and financial risk
2
Capital Structure Defined 
The term capital structure is used to represent the 
proportionate relationship between debt and equity.
The various means of financing represent the financial 
structure of an enterprise. The left-hand side of the 
balance sheet (liabilities plus equity) represents the 
financial structure of a company. Traditionally, short-
term borrowings are excluded from the list of methods 
of financing the firm’s capital expenditure.
3
Page 4


FINANCIAL AND 
OPERATING 
LEVERAGE
LEARNING OBJECTIVES
Explain the concept of financial leverage
 Discuss the alternative measures of financial 
leverage
 Understand the risk and return implications 
of financial leverage
 Analyze the combined effect of financial and 
operating leverage
 Highlight the difference between operating 
risk and financial risk
2
Capital Structure Defined 
The term capital structure is used to represent the 
proportionate relationship between debt and equity.
The various means of financing represent the financial 
structure of an enterprise. The left-hand side of the 
balance sheet (liabilities plus equity) represents the 
financial structure of a company. Traditionally, short-
term borrowings are excluded from the list of methods 
of financing the firm’s capital expenditure.
3
 While making the Financing Decision...
How should the investment project be financed?
Does the way in which the investment projects are   
financed matter?
How does financing affect the shareholders’ risk, return and 
value?
Does there exist an optimum financing mix in terms of the 
maximum  value to the firm’s shareholders?
Can the optimum financing mix be determined in practice  
for a company?
What factors in practice should a company consider in 
designing its financing policy?
4
Page 5


FINANCIAL AND 
OPERATING 
LEVERAGE
LEARNING OBJECTIVES
Explain the concept of financial leverage
 Discuss the alternative measures of financial 
leverage
 Understand the risk and return implications 
of financial leverage
 Analyze the combined effect of financial and 
operating leverage
 Highlight the difference between operating 
risk and financial risk
2
Capital Structure Defined 
The term capital structure is used to represent the 
proportionate relationship between debt and equity.
The various means of financing represent the financial 
structure of an enterprise. The left-hand side of the 
balance sheet (liabilities plus equity) represents the 
financial structure of a company. Traditionally, short-
term borrowings are excluded from the list of methods 
of financing the firm’s capital expenditure.
3
 While making the Financing Decision...
How should the investment project be financed?
Does the way in which the investment projects are   
financed matter?
How does financing affect the shareholders’ risk, return and 
value?
Does there exist an optimum financing mix in terms of the 
maximum  value to the firm’s shareholders?
Can the optimum financing mix be determined in practice  
for a company?
What factors in practice should a company consider in 
designing its financing policy?
4
Meaning of Financial Leverage 
The use of the fixed-charges sources of funds, such as debt 
and preference capital along with the owners’ equity in the 
capital structure, is described as financial leverage or 
gearing or trading on equity. 
The financial leverage employed by a company is intended 
to earn more return on the fixed-charge funds than their 
costs. The surplus (or deficit) will increase (or decrease) the 
return on the owners’ equity. The rate of return on the 
owners’ equity is levered above or below the rate of return 
on total assets. 
5