Learn the concept of financial risk and financial leverage, explore how the degree of financial leverage affects profitability and stability, and understand its implications in corporate decision-making. A complete guide for BITM 6th Sem students studying Fundamentals of Corporate Finance.
Thank you for reading this post, don't forget to subscribe!Introduction to Financial Risk and Financial Leverage
In corporate finance, financial risk and financial leverage are two fundamental concepts that influence a firm’s profitability, solvency, and capital structure decisions. Every business uses a mix of debt and equity to finance its operations. However, the extent to which debt is used determines the company’s financial leverage — and this leverage, in turn, introduces financial risk.
For students of BITM 6th Semester (Fundamentals of Corporate Finance), understanding these two terms is essential to analyze how financing decisions affect the overall performance and risk profile of a firm.
What is Financial Risk?
Financial Risk refers to the possibility that a company may fail to meet its financial obligations, particularly interest payments and repayment of principal on borrowed funds.
- It arises due to the use of fixed financial charges like interest on debt or preference dividends.
In simple terms, financial risk measures the uncertainty in a company’s earnings due to the use of debt financing. The higher the proportion of debt in the capital structure, the higher the financial risk.
Example of Financial Risk
Suppose a company uses a large amount of debt to finance its operations. Even if the firm’s sales decline, it must still pay interest to lenders. This increases the chance of financial distress — a clear example of financial risk.
Factors Affecting Financial Risk
- Capital Structure Composition:
Companies with higher debt-to-equity ratios face greater financial risk. More equity reduces financial burden and stabilizes returns. - Cost of Debt:
High interest rates increase the fixed cost burden, thus magnifying financial risk. - Operating Income Stability:
Firms with stable earnings can handle debt more easily, while volatile income amplifies financial risk. - Liquidity Position:
Companies with strong liquidity can meet short-term obligations, reducing financial risk. - Economic and Market Conditions:
Recessions, inflation, or interest rate fluctuations can affect the company’s ability to service debt. - Financial Management Efficiency:
Poor financial planning or excessive borrowing increases the probability of default and risk.
What is Financial Leverage?
Financial Leverage refers to the use of fixed-charge financing sources such as debt or preference shares to increase the potential return to equity shareholders.
- It shows how sensitive the company’s earnings per share (EPS) or net income is to changes in operating profit (EBIT).
In other words, financial leverage magnifies both profits and losses — acting as a double-edged sword in financial management.
Implications of Financial Leverage
1. Impact on Earnings Per Share (EPS):
High financial leverage increases EPS when EBIT rises but decreases it sharply when EBIT falls.
2. Risk–Return Trade-Off:
Using more debt can increase returns for shareholders (due to tax benefits of interest) but also increases the risk of insolvency.
3. Effect on Cost of Capital:
Beyond a certain point, high debt raises the company’s overall cost of capital due to increased perceived risk by investors.
4. Control Considerations:
Debt financing allows existing owners to maintain control, as issuing more equity dilutes ownership.
5. Financial Flexibility:
Firms with low leverage retain flexibility to raise funds in the future, while highly leveraged firms face restricted borrowing capacity.
6. Bankruptcy Risk:
Excessive leverage increases the chance of financial distress or bankruptcy during downturns.
Relationship Between Financial Risk and Financial Leverage
There is a direct relationship between financial risk and financial leverage.
When a firm increases its use of debt, its financial leverage rises — this leads to a higher financial risk because the firm must meet fixed obligations regardless of its earnings.
Hence, financial managers aim to maintain an optimal level of financial leverage that balances the benefits of debt (tax advantage, increased EPS) against the potential risk of default.
Difference Between Operating Leverage and Financial Leverage
| Basis | Operating Leverage | Financial Leverage |
|---|---|---|
| Nature | Arises from fixed operating costs | Arises from fixed financial costs |
| Measured by | Degree of Operating Leverage (DOL) | Degree of Financial Leverage (DFL) |
| Risk Type | Business Risk | Financial Risk |
| Focus | Impact of sales change on EBIT | Impact of EBIT change on EPS |
| Source | Fixed operating expenses | Debt and preference capital |
| Effect | Influences business risk | Influences financial risk |
Conclusion
Understanding financial risk, financial leverage, and their degree and implications is vital for every business and finance student.
Effective leverage management enables firms to maximize shareholder returns while maintaining financial stability.
For BITM 6th Semester students, mastering these concepts forms the foundation for advanced topics in capital structure, risk management, and corporate valuation.
In short:
“Leverage is powerful — but with great power comes great responsibility.”
Frequently Asked Questions (FAQs)
1. What is financial risk in corporate finance?
Financial risk refers to the possibility that a firm may fail to meet its fixed financial obligations due to excessive use of debt.
2. How is the degree of financial leverage calculated?
DFL = EBIT ÷ (EBIT – Interest). It shows how changes in operating income affect earnings per share.
3. What are the implications of high financial leverage?
High leverage increases potential returns during profitable periods but raises the risk of loss during downturns.
4. How are financial and operating leverage different?
Operating leverage deals with fixed operating costs, while financial leverage deals with fixed financial costs like interest.
5. Why is an optimal financial leverage important?
It ensures the firm enjoys the benefits of debt (like tax savings) without exposing itself to excessive financial risk.