The Impact of Financial Leverage on Return and Risk

Abstract

Financing with debt and preferred stock to increase the potential return to the residual common shareholders' equity is referred to as financial leverage. A firm's return on equity (ROE) is a key determinant of the growth rate of its earnings. Return on equity is affected profoundly by the firm's degree of financial leverage. Increased debt will make a positive contribution to a firm's ROE only if the firm's return on assets (ROA) exceeds the interest rate on the debt. In spite of the fact that financial leverage increases the rate of return on common stock equity, the grater the proportion of debt in the capital structure, however, the greater the risk the common shareholders bear. Introduction of financial leverage increases the average profitability of the firm as well as its risk. In good economic years, the impact of financial leverage will most likely be positive; however, the leverage effect may be negative in relatively bad years. Traditionally, studies treated short-term debt and long-term debt as perfect substitutes for each other. There is, however, risk-sharing by long-term debtholders which makes short-term debt financing riskier to shareholders than long-term debt financing. The significant affect associated with the total debt usage is largely attributable to short-term debt financing, since the impact of short-term debt financing on the expected returns is shown to be greater than that of long-term debt financing.