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.

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