Answers:
Financial leverage relates to the financing activities
of a firm and measures the effect of EBIT on Earnings Per Share (EPS) of the
company.
A company’s sources of funds fall under two
categories:
- Those which carry fixed financial charges like debentures, bonds,
and preference shares
- Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest
and are to be paid off irrespective of the firm’s revenues. The dividends are
not contractual obligations, but the dividend on preference shares is a fixed
charge and should be paid off before equity shareholders. The equity holders
are entitled to only the residual income of the firm after all prior
obligations are met.