A Study on Effect of Financial Leverage on Profitability and Risk

Abstract

A financial leverage is also important in the financial performance of a firm and its level of risk. This paper analyzes how financial leverage influences the profitability and risk in an organization. Financial leverage is the use of the borrowed finances or debt to directly fund business operations and investments, with the hope of making higher returns to shareholders. Although leverage can be used to increase the profitability, it can also escalate the financial risk of the firm as it has fixed interest payments. The primary purpose of the research is to determine the effect of financial leverage on the indicators of profitability including Return on Equity (ROE), Return on Assets (ROA) and Net Profit Margin, and level of risk of financial risk of the company. The research is premised by secondary information obtained through the financial statements of the targeted company within a given duration. The relationship between leverage, profitability, and risk is analyzed with the help of different financial ratios and analytical tools. The study findings are useful in knowing whether an increase in the leverage results in an increase in profitability or an increase in the financial risk of the organization. The study also offers knowledge to managers as well as investors in making sound financial choices on capital structure and debt management. On the whole, the research also shows the significance of a good debt-equity ratio in order to have sustainable financial performance and reduce financial risk.