Definition of financial leverage

financial leverage

Debt financing amplifies the effects of changes in operating income on the returns to stockholders.

financial leverage

The equity (ownership) capital of a business can serve
as the basis for securing debt capital (borrowing money). In this way, a
business increases the total capital available to invest in its assets and
can make more sales and more profit. The strategy is to earn operating
profit, or earnings before interest and income tax (EBIT), on the capital
supplied from debt that is more than the interest paid on the debt capital.
A financial leverage gain equals the EBIT earned on debt capital
minus the interest on the debt. A financial leverage gain augments earnings
on equity capital. A business must earn a rate of return on its assets
(ROA) that is greater than the interest rate on its debt to make a financial
leverage gain. If the spread between its ROA and interest rate is unfavorable,
a business suffers a financial leverage loss.

Financial leverage

Use of debt to increase the expected return on equity. financial leverage is measured by
the ratio of debt to debt plus equity.

Financial leverage clientele

A group of investors who have a preference for investing in firms that adhere to
a particular financial leverage policy.

Financial leverage ratios

Related: capitalization ratios.

Capitalization ratios

Also called financial leverage ratios, these ratios compare debt to total capitalization
and thus reflect the extent to which a corporation is trading on its equity. Capitalization ratios can be
interpreted only in the context of the stability of industry and company earnings and cash flow.

Debt/equity ratio

Indicator of financial leverage. Compares assets provided by creditors to assets provided
by shareholders. Determined by dividing long-term debt by common stockholder equity.

Gearing

financial leverage.

Leveraged equity

Stock in a firm that relies on financial leverage. Holders of leveraged equity face the
benefits and costs of using debt.

Long-term debt/capitalization

Indicator of financial leverage. Shows long-term debt as a proportion of the
capital available. Determined by dividing long-term debt by the sum of long-term debt, preferred stock and
common stockholder equity.

Return on equity (ROE)

Indicator of profitability. Determined by dividing net income for the past 12
months by common stockholder equity (adjusted for stock splits). Result is shown as a percentage. Investors
use ROE as a measure of how a company is using its money. ROE may be decomposed into return on assets
(ROA) multiplied by financial leverage (total assets/total equity).

Sustainable growth rate

Maximum rate of growth a firm can sustain without increasing financial leverage.

return on assets (ROA)

Although there is no single uniform practice for
calculating this ratio, generally it equals operating profit (before interest
and income tax) for a year divided by the total assets that are used to
generate the profit. ROA is the key ratio to test whether a business is
earning enough on its assets to cover its cost of capital. ROA is used for
determining financial leverage gain (or loss).

Leverage

The relationship between interest bearing debt and equity in a company(financial leverage) or the effect of fixed expense on after tax earnings(operating leverage).

Changes in Financial Position

Sources of funds internally provided from operations that alter a company's
cash flow position: depreciation, deferred taxes, other sources, and capital expenditures.

Corporate financial management

The application of financial principals within a corporation to create and
maintain value through decision making and proper resource management.

Corporate financial planning

financial planning conducted by a firm that encompasses preparation of both
long- and short-term financial plans.

Country financial risk

The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.

Debt leverage

The amplification of the return earned on equity when an investment or firm is financed
partially with borrowed money.

Dupont system of financial control

Highlights the fact that return on assets (ROA) can be expressed in terms
of the profit margin and asset turnover.

Financial analysts

Also called securities analysts and investment analysts, professionals who analyze
financial statements, interview corporate executives, and attend trade shows, in order to write reports
recommending either purchasing, selling, or holding various stocks.

Financial assets

Claims on real assets.

Financial control

The management of a firm's costs and expenses in order to control them in relation to
budgeted amounts.

Financial distress

Events preceding and including bankruptcy, such as violation of loan contracts.

Financial distress costs

Legal and administrative costs of liquidation or reorganization. Also includes
implied costs associated with impaired ability to do business (indirect costs).

Financial engineering

Combining or dividing existing instruments to create new financial products.

Financial future

A contract entered into now that provides for the delivery of a specified asset in exchange
for the selling price at some specified future date.

Financial intermediaries

Institutions that provide the market function of matching borrowers and lenders or
traders.

Financial lease

Long-term, non-cancelable lease.

Financial market

An organized institutional structure or mechanism for creating and exchanging financial assets.

Financial objectives

Objectives of a financial nature that the firm will strive to accomplish during the period
covered by its financial plan.

Financial plan

A financial blueprint for the financial future of a firm.

Financial planning

The process of evaluating the investing and financing options available to a firm. It
includes attempting to make optimal decisions, projecting the consequences of these decisions for the firm in
the form of a financial plan, and then comparing future performance against that plan.

Financial press

That portion of the media devoted to reporting financial news.

Financial ratio

The result of dividing one financial statement item by another. Ratios help analysts interpret
financial statements by focussing on specific relationships.

Financial risk

The risk that the cash flow of an issuer will not be adequate to meet its financial obligations.
Also referred to as the additional risk that a firm's stockholder bears when the firm utilizes debt and equity.

Highly leveraged transaction (HLT)

Bank loan to a highly leveraged firm.

Homemade leverage

Idea that as long as individuals borrow (or lend) on the same terms as the firm, they can
duplicate the affects of corporate leverage on their own. Thus, if levered firms are priced too high, rational
investors will simply borrow on personal accounts to buy shares in unlevered firms.

Leverage

The use of debt financing.

Leverage clientele

A group of shareholders who, because of their personal leverage, seek to invest in
corporations that maintain a compatible degree of corporate leverage.

Leverage ratios

Measures of the relative contribution of stockholders and creditors, and of the firm's ability
to pay financing charges. Value of firm's debt to the total value of the firm.

Leverage rebalancing

Making transactions to adjust (rebalance) a firm's leverage ratio back to its target.

Leveraged beta

The beta of a leveraged required return; that is, the beta as adjusted for the degree of
leverage in the firm's capital structure.

Leveraged buyout (LBO)

A transaction used for taking a public corporation private financed through the use
of debt funds: bank loans and bonds. Because of the large amount of debt relative to equity in the new
corporation, the bonds are typically rated below investment grade, properly referred to as high-yield bonds or
junk bonds. Investors can participate in an LBO through either the purchase of the debt (i.e., purchase of the
bonds or participation in the bank loan) or the purchase of equity through an LBO fund that specializes in
such investments.

Leveraged lease

A lease arrangement under which the lessor borrows a large proportion of the funds needed
to purchase the asset and grants the lender a lien on the assets and a pledge of the lease payments to secure the
borrowing.

Leveraged portfolio

A portfolio that includes risky assets purchased with funds borrowed.

Leveraged required return

The required return on an investment when the investment is financed partially by debt.

London International Financial Futures Exchange (LIFFE)

A London exchange where Eurodollar futures
as well as futures-style options are traded.

Long-term financial plan

financial plan covering two or more years of future operations.

Leverage

he use of debt financing.

Leveraged portfolio

A portfolio that includes risky assets purchased with funds borrowed.

London International Financial Futures Exchange (LIFFE)

London exchange where Eurodollar futures as well as futures-style options are traded.

Net benefit to leverage factor

A linear approximation of a factor, T*, that enables one to operationalize the
total impact of leverage on firm value in the capital market imperfections view of capital structure.

Non-financial services

Include such things as freight, insurance, passenger services, and travel.

Notes to the financial statements

A detailed set of notes immediately following the financial statements in
an annual report that explain and expand on the information in the financial statements.

Operating leverage

Fixed operating costs, so-called because they accentuate variations in profits.

Perfectly competitive financial markets

Markets in which no trader has the power to change the price of
goods or services. Perfect capital markets are characterized by the following conditions: 1) trading is costless,
and access to the financial markets is free, 2) information about borrowing and lending opportunities is freely
available, 3) there are many traders, and no single trader can have a significant impact on market prices.

Pro forma financial statements

financial statements as adjusted to reflect a projected or planned transaction.

Short-term financial plan

A financial plan that covers the coming fiscal year.

Society for Worldwide Interbank Financial Telecommunications (SWIFT)

A dedicated computer network to support funds transfer messages internationally between over 900 member banks worldwide.

Statement of Financial Accounting Standards No. 8

This is a currency translation standard previously in
use by U.S. accounting firms. See: Statement of Accounting Standards No. 52.

Statement of Financial Accounting Standards No. 52

This is the currency translation standard currently
used by U.S. firms. It mandates the use of the current rate method. See: Statement of financial Accounting
Standards No. 8.

Unleveraged beta

The beta of an unleveraged required return (i.e. no debt) on an investment when the
investment is financed entirely by equity.

Unleveraged required return

The required return on an investment when the investment is financed entirely
by equity (i.e. no debt).

Financial accounting

The production of financial statements, primarily for those interested parties who are external to the business.

Financial reports or statements

The Profit and Loss account, Balance Sheet and Cash Flow statement of a business.

Financial year

The accounting period adopted by a business for the production of its financial statements.
Finished goods Inventory that is ready for sale, either having been purchased as such or the result of a conversion from raw materials through a manufacturing process.

statement of financial condition

See balance sheet.

financial reports and statements

financial means having to do with
money and economic wealth. Statement means a formal presentation.
financial reports are printed and a copy is sent to each owner and each
major lender of the business. Most public corporations make their financial
reports available on a web site, so all or part of the financial report
can be downloaded by anyone. Businesses prepare three primary financial
statements: the statement of financial condition, or balance sheet;
the statement of cash flows; and the income statement. These three key
financial statements constitute the core of the periodic financial reports
that are distributed outside a business to its shareowners and lenders.
financial reports also include footnotes to the financial statements and
much other information. financial statements are prepared according to
generally accepted accounting principles (GAAP), which are the authoritative
rules that govern the measurement of net income and the reporting
of profit-making activities, financial condition, and cash flows.
Internal financial statements, although based on the same profit
accounting methods, report more information to managers for decision
making and control. Sometimes, financial statements are called simply
financials.

operating leverage

A relatively small percent increase or decrease in
sales volume that causes a much larger percent increase or decrease in
profit because fixed expenses do not change with small changes in sales
volume. Sales volume changes have a lever effect on profit. This effect
should be called sales volume leverage, but in practice it is called operating
leverage.
operating liabilities
The short-term liabilities generated by the operating
(profit-making) activities of a business. Most businesses have three types
of operating liabilities: accounts payable from inventory purchases and
from incurring expenses, accrued expenses payable for unpaid expenses,
and income tax payable. These short-term liabilities of a business are
non-interest-bearing, although if not paid on time a business may be
assessed a late-payment penalty that is in the nature of an interest
charge.

degree of operating leverage

a factor that indicates how a percentage change in sales, from the existing or current
level, will affect company profits; it is calculated as contribution
margin divided by net income; it is equal to (1 - margin of safety percentage)

financial accounting

a discipline in which historical, monetary
transactions are analyzed and recorded for use in the
preparation of the financial statements (balance sheet, income
statement, statement of owners’/stockholders’ equity,
and statement of cash flows); it focuses primarily on the
needs of external users (stockholders, creditors, and regulatory
agencies)

financial budget

a plan that aggregates monetary details
from the operating budgets; includes the cash and capital
budgets of a company as well as the pro forma financial
statements

financial incentive

a monetary reward provided for performance
above targeted objectives

operating leverage

the proportionate relationship between
a company’s variable and fixed costs

Leveraged buyout

The purchase of one business entity by another, largely using borrowed
funds. The borrowings are typically paid off through the future cash flow of
the purchased entity.

chief financial officer (CFO)

Officer who oversees the treasurer and controller and sets overall financial strategy.

costs of financial distress

Costs arising from bankruptcy or distorted business decisions before bankruptcy.

degree of operating leverage (DOL)

Percentage change in profits given a 1 percent change in sales.

financial assets

Claims to the income generated by real assets. Also called securities.

financial intermediary

Firm that raises money from many small investors and provides financing to businesses or other
organizations by investing in their securities.

financial markets

Markets in which financial assets are traded.

financial risk

Risk to shareholders resulting from the use of debt.

financial slack

Ready access to cash or debt financing.

leveraged buyout (LBO)

Acquisition of the firm by a private group using substantial borrowed funds.

operating leverage

Degree to which costs are fixed.

Financial Intermediary

Any institution, such as a bank, that takes deposits from savers and loans them to borrowers.

Financial Intermediation

The process whereby financial intermediaries channel funds from lender/savers to borrower/spenders.

Financial Covenant

A feature of a debt or credit agreement that is designed to protect the lender or creditor. It is common to characterize covenants as either positive or negative covenants.
A positive covenant might require that the debtor maintain a minimum amount of working capital.
A negative covenant might limit dividend payments that may be made.

Financial Numbers Game

The use of creative accounting practices to alter a financial statement
reader's impression of a firm's business performance.

Fraudulent Financial Reporting

Intentional misstatements or omissions of amounts or disclosures
in financial statements done to deceive financial statement users. The term is used interchangeably
with accounting irregularities. A technical difference exists in that with fraud, it
must be shown that a reader of financial statements that contain intentional and material misstatements
must have used those financial statements to his or her detriment. In this book, accounting
practices are not alleged to be fraudulent until done so by an administrative, civil, or
criminal proceeding, such as that of the Securities and Exchange Commission, or a court.

Restatement of Prior-Year Financial Statements

A recasting of prior-year financial statements to remove the effects of an error or other adjustment and report them on a new basis.

External Financial Statements

Corporate financial statements that have been reported on by an external independent accountant.

Financial Assistance

Economic assistance provided by unrelated third parties, typically government agencies. They may take the form of loans, loan guarantees, subsidies, tax allowances, contributions, or cost-sharing arrangements.

Financial Covenants

A promise made related to financial conditions or events. Often a promise not to allow certain balance sheet items or ratios to fall below an agreed level. Usually found in loan documents, as a protection mechanism.

Financial Incentive

An expression of economic benefit that motivates behavior that might otherwise not take place.

Financial Lease

Lease in which the service provided by the lessor to the lessee is limited to financing equipment. All other responsibilities related to the possession of equipment, such as maintenance, insurance, and taxes, are borne by the lessee. A financial lease is usually noncancellable and is fully paid out amortized over its term.

Financial Position

Status of a firm's assets, liabilities, and equity accounts as of a certain time, as shown in its financial statement.

Financial Trend Analysis

Process of analyzing financial statements of a company for any continuing relationship.

Future-Oriented Financial Information

Information about prospective results of operations, financial position and/or changes in financial position, based on assumptions about future economic conditions and courses of action. Future-oriented financial information is presented as either a forecast or a projection.

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