Relationships in Corporate Governance
The term ‘Principal-agent relationship’ or just simply, ‘Agency relationship’ is used to describe... Read More
Financial leverage refers to the extent to which a company finances its operations using fixed-cost financial obligations such as debt and preferred equity. The more a company uses debt financing, the higher its financial leverage and exposure to financial risk.
Effect of Financial Leverage on Net Income and Return on Equity
A high degree of financial leverage implies that a company has high levels of interest payments which could negatively impact its net income, bottom-line earnings per share, as well as return on equity (ROE). However, financial leverage really increases the variability of a company’s net income and its return on equity. This means that the net income and return on equity of a company can either increase or decrease depending on the impact of other factors such as the macroeconomic environment.
An increase in a company’s reliance on debt financing increases its risk of default. Besides, it increases the likelihood that the company’s operating earnings, net income, and ROE will increase in good economic times. Ultimately, financial leverage increases the risk for a company’s shareholders. It is noteworthy that finacial leverage has the potential to magnify the returns shareholders receive from their shares.
Upon attainment of what would be considered optimal financial leverage, both a company’s net income and its ROE will increase. However, if a company is financially over-leveraged, then a decrease in both net income and return on equity could occur.
Question
Which of the following statements most accurately describes the effect of financial leverage on a company’s net income and return on equity?
A. An increase in financial leverage always results in an increase in a company’s net income and return on equity.
B. An increase in financial leverage always results in a decrease in a company’s net income and return on equity.
C. An increase in financial leverage may result either in an increase or decrease in a company’s net income and return on equity.
Solution
The correct answer is C.
Financial leverage increases the variability of a company’s net income and return on equity and may result either in an increase or decrease of the two.
Options A and B are incorrect because they assume that financial leverage can have only one effect, either an increase or a decrease in net income and return on equity. This is not the case.
Reading 34 LOS 34c:
Analyze the effect of financial leverage on a company’s net income and return on equity
Sergio Torrico
2021-07-23
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2021-07-17
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