# Why Is Financial Leverage Important?

Most of these companies, many of which are from Hollywood, forgot that they still had to repay their debts even if the projects they financed with the funds failed. To use leverage successfully, a company must use realistic projections, sound management decisions, common sense, and an unbiased appraisal of the risks. If the company opts for the first option, it will own 100% of the asset, and there will be no interest payments. If the asset appreciates in value by 30%, the asset’s value will increase to $130,000 and the company will earn a profit of $30,000.

- For this reason, financial leverage is measured based on how additional debt affects the earnings per share of common stockholders.
- This combines operating leverage, which measures fixed costs and assets, with the debt financing measured by financial leverage.
- Therefore, corporate management must use a thorough and prudent process for establishing a company’s target capital structure.
- Both of these ratios compare the company’s current assets to its current liabilities.
- Let us assume that after one year the value of the 40 houses David bought increases by 20% (selling price of $600,000 minus the houses’ cost of $500,000).
- A lot of things can go wrong and some of them would be discussed below.
- Debt reduces the cost of capital and makes the capital structure more optimal.

As the name implies, these ratios are used to measure the ability of the company to meet its short-term obligations. Two of the most utilized short-term liquidity ratios are the current ratio and acid-test ratio. Both of these ratios compare the company’s current assets to its current liabilities.

## Tier 1 Leverage Ratio

Specifically, the ratio of fixed and variable costs that a company uses determines the amount of operating leverage employed. A company with a greater ratio of fixed to variable costs is said to be using more operating leverage. Operating leverage measures the sensitivity of a company’s operating income to its sales. It is the ratio of fixed costs to variable costs of a company in a specific successful use of financial leverage requires a firm to period. One of the financial ratios used in determining the amount of financial leverage a business has is the debt/equity ratio, which shows the proportion of debt a firm has compared to the equity of its shareholders. The use of financial leverage in bankrolling a firm’s operations can improve the returns to shareholders without diluting the firm’s ownership through equity financing.

Increased stock prices will mean that the company will pay higher interest to the shareholders. Alternatively, the company may go with the second option and finance the asset using 50% common stock and 50% debt. If the asset appreciates by 30%, the asset will be valued at $130,000.