Financial Leverage, Net Income, and ROE

Financial leverage is 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-interest payments, which could negatively impact its net income, bottom-line earnings per share, and return on equity (ROE). However, financial leverage increases the variability of a company’s net income and its return on equity. This means that a company’s net income and return on equity 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 financial leverage can magnify the returns shareholders receive from their shares.

A company’s net income and its ROE will increase upon attainment of what would be considered optimal financial leverage. However, if a company is financially over-leveraged, then both net income and return on equity could decrease.

Question

Which of the following statements most accurately describes the effect of financial leverage on a company’s net income and return on equity?

1. An increase in financial leverage always increases a company’s net income and return on equity.
2. An increase in financial leverage always decreases a company’s net income and return on equity.
3. An increase in financial leverage may either increase or decrease 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 either increase or decrease 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.