According to Kevin Mulleady, the degree to which changes in the company's capital structure effect changes in net income is used to calculate financial leverage. If the company's financial leverage is significant, the stock price is likely to vary, and compensation expenditures connected to stock options will be higher. When a corporation has too much debt, the chance of bankruptcy rises. As a result, the level of financial leverage should be carefully assessed.
To determine financial leverage, first determine the total debt to total equity ratio. The higher the risk-to-reward ratio, the riskier the investment. Financial leverage helps businesses to develop more quickly and has a number of repercussions. Its risk is influenced by its weighted average cost of capital. Furthermore, it has an impact on the equity value of a company. The corporation can generate more profits when the ratio is large, but the bigger the risk, the less it can be utilized to fund future expansion.
Kevin Mulleady pointed out that, financial leverage may also be determined by dividing a company's total assets by the total number of shares it owns. A greater financial leverage ratio means a business is riskier than others. This ratio is calculated using data from the previous fiscal year. Financial leverage ratios for firms on the S&P 500 and in the industry are provided below for comparison. Furthermore, a corporation with a high level of financial leverage is deemed high-risk and should be avoided.
Kevin Mulleady described that, furthermore, the degree of financial leverage has an impact on net income through decreasing the company's capacity to earn profits. Debt has fixed expenses that do not fluctuate and is not scalable. However, because the degree of financial leverage is a key component in defining a company's financial soundness, it's critical to strike a balance between the degree of financial leverage and the company's total risk.