The leverage associated with the use of fixed cost/return source of funds in known as financial leverage. The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage.
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The long term fixed interest bearing debt is employed by a firm to earn more from the use of these resources than their cost so as to increase the return on owner’s equity. The aim of financial leverage is to increases the revenue available for equity shareholders using the fixed cost funds.
ADVERTISEMENTS:
If the revenue earned by employing fixed cost funds is more than their cost (interest and preference dividend) then it will be to the benefit of equity shareholders to use such a capital structure. A firm is known to have a favourable leverage if its earnings are more than what debt would cost.
Limitations:
1. The financial leverage or trading on equity suffers from the following limitations:
Be successfully employed to increase the earnings of the shareholders only when the rate of earnings of the company is more than the fixed rate of interest/dividend on debentures/ preference shares. On the other hand, if it does not earn as much as the cost of interest bearing securities, then it will work adversely and hence cannot be employed.
2. Beneficial only to companies having stability of Earnings:
Trading on equity is beneficial only to the companies having stable and regular earnings. This is so because interest on debentures is a recurring burden on the company and a company having irregular income cannot pay interest on its borrowing during lean years.
3. Increases Risk and Rate of Interest:
Another limitation of trading on equity is on account of the fact that every rupee of extra debt increases the risk and hence the rate of interest on subsequent loans also goes on increasing. It becomes difficult for the company to obtain further debts without offering extra securities and higher rates of interest reducing their earnings.
4. Restrictions from Financial Institutions:
ADVERTISEMENTS:
The financial institutions also impose restrictions on companies which resort to excessive trading on equity because of the risk factor and to maintain a balance in the capital structure of the company.