Impact of Financial Leverage on Net Income and ROE

No fixed financing costs: If a firm has no fixed financing cost, then there is no financial leverage.  In such a firm, when EBIT rises or falls, the earnings per share will also rise and fall by the same percentage.  For example, a 10% increase in EBIT will result in a 10% increase in EPS; a 10% decrease in EBIT will result in a 10% decrease in EPS.

Has fixed financing costs: If a firm has fixed financing costs, it is said to have financial leverage.  In such a firm, when EBIT rises or falls, the earnings per share will also rise and fall by a greater percentage.  For example, a 10% increase in EBIT will result in a more-than-10% increase in EPS; a 10% decrease in EBIT will result in a more-than-10% decrease in EPS.

This happens because the interest expense (fixed financing cost) decreases the net income; however, even though the net income is lower, it is distributed to a smaller base of shareholder's equity (firm is part equity financed and part debt financed).  This magnifies the impact on EPS and ROE.

This content is for paid members only.

Join our membership for lifelong unlimited access to all our data science learning content and resources.

Related Downloads

Related Quizzes

Measures of Leverage