Financial Leverage Explained. CPA Exam BAR скачать в хорошем качестве

Financial Leverage Explained. CPA Exam BAR

In this video, we explain the financial leverage as covered in a finance course and CPA BAR exam. Start your free trial: https://farhatlectures.com/ Financial leverage is a concept that refers to the strategy a company employs in its financing decisions, focusing on the mix of debt and equity it uses to fund operations and growth. When a company issues debt, it obligates itself to pay fixed interest costs on that debt, regardless of its financial performance. This is in contrast to equity financing, where the company raises money by selling shares. Equity does not increase the company's fixed costs since dividends, unlike interest payments, are not mandatory and can be adjusted based on the company's profitability. The essence of financial leverage lies in the company's preference for using borrowed funds (debt) over raising funds through equity (selling shares). This preference is not without its reasons. Using debt can amplify the returns on investment when the company is performing well, as the cost of debt (interest expense) is often lower than the return the company earns on its investments. This means that after paying the fixed interest costs, the remaining profits generated from the investments funded by debt can significantly increase the earnings available to shareholders. However, financial leverage is a double-edged sword. While it can magnify profits in good times, it can also exacerbate losses when the company's investments do not perform as expected. This is because the interest costs on debt are fixed and must be paid regardless of the company's financial health, potentially putting the company at risk if it cannot cover these costs. In summary, financial leverage is a critical aspect of a company's financial strategy, reflecting its choice between using debt or equity to finance its operations. This choice has significant implications for the company's risk profile and potential for returns, influencing not only the company's financial performance but also its attractiveness to investors. When a company opts to finance its operations through debt, it takes on the responsibility to generate enough earnings before interest and taxes (EBIT) to meet its fixed interest payments. Successfully covering these fixed costs means that any additional EBIT directly contributes to the company's net income and, consequently, its earnings per share (EPS). This relationship underscores the impact of financial leverage on a company's profitability, illustrating how leveraging debt can significantly amplify profits beyond the threshold of covering fixed interest expenses. The degree of financial leverage a company employs plays a crucial role in determining its financial sensitivity. Specifically, a company with high financial leverage will experience more pronounced fluctuations in its profits and shareholder value in response to changes in EBIT, whether those changes are positive or negative. This heightened sensitivity arises because, with high leverage, a small increase in EBIT can lead to a substantial rise in net income after covering fixed interest costs. Conversely, a minor decline in EBIT can disproportionately affect net income, as the fixed interest costs consume a larger portion of the diminished earnings. An additional advantage of using debt over equity is the tax deductibility of interest expenses. This means that the actual cost of debt is reduced by the tax savings generated from deducting interest costs, making debt an attractive financing option from a tax perspective. Unlike interest expenses, dividends paid to shareholders are not tax-deductible, which can make equity financing less attractive in certain situations. However, the strategy of employing high financial leverage is not without risks. Companies with substantial debt obligations face the constant challenge of generating enough income to meet their interest payments. Failure to do so can lead to financial distress and, in the worst-case scenario, bankruptcy. Moreover, a company's history of high leverage and struggles to meet debt obligations can tarnish its reputation with lenders, potentially limiting its ability to secure financing in the future. This situation can constrain a company's growth opportunities and ability to respond to competitive pressures, emphasizing the need for careful consideration and management of financial leverage. #cpaexaminindia #cpaexam #financialeducation