Financial leverage results from the presence of fixed financial charges in the firm’s income stream. These fixed charges do not vary with the earnings before interest and tax (EBIT) or operating profits. They have to be paid regardless of the amount of earnings before interest and taxes available to pay them. After paying them, the operating profits (EBIT) belong to the ordinary shareholders.
Financial leverage is concerned with the effects of changes in earnings before interest and taxes on the earnings available to equity holders. It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the firm’s earning per share. Financial leverage and trading on equity are synonymous terms.
The EBIT is calculated by adding back the interest (interest on loan capital + interest on long term loans + interest on other loans) and taxes to the amount of net profit. Financial leverage ratio is calculated by dividing EBIT by EBT (earnings before tax). Neither a very high leverage nor a very low leverage represents a sound picture. (EBIT ÷ EBT).