Financial Leverage Essay Example | Topics and Well Written Essays - 2250 words

Financial Leverage - Essay Example Higher expected returns are associated with the firms that are having high financial leverage ratios when the economy of a country is normal. Whereas, when the economy of a country is in recession so firms having high financial leverage ratios will face risk of loss. On the other hand, firms having low financial leverage ratios are supposed to be less risky but higher expected returns are not associated with these firms. IMPORTANCE OR AIM OF THE STUDY The importance or aim of this study is to show that analysts use financial leverage ratios to accomplish two things: †¢First, they are a measure of the extent to which firms finance their assets through debt. †¢Second, they are the indicators of the financial risk of the firm. Analysis of a firm’s financial leverage ratios is essential to evaluate its long-term risk and return prospects. Leverage as a debt-financing indicator is important because whenever a firm’s rate of return on assets is in access of interest rate, the profits to equity investors are magnified in direct proportions to increases in leverage. The reverse also holds true-whenever the rate of return falls below the interest rate, the profits to investors decline with increases in leverage. In fact, if the firm is sufficiently levered, interest expenses may be so high that under adverse economic conditions the firm may not be capable of paying them-that is, financial risk is directly proportional to leverage. In conclusion it can be said that analysis of a firm’s financial leverage ratios is essential to evaluate its long-term risk and return prospects. Leveraged firms accrue excess returns to their shareholders so long as the rate of return on the investments financed by debt is greater than the cost of debt.