What does financial leverage measure?

Question

What does financial leverage measure?

1. A. No change with EBIT and EPS
2. B. The sensibility of EBIT with % change with respect to output
3. C. The sensibility of EPS w.r.t % change in the EBIT level (Correct answer)
4. D. % variation in the level of production

Correct Answer

Option C — The sensibility of EPS w.r.t % change in the EBIT level

Detailed Solution & Explanation

The correct answer is The sensibility of EPS w.r.t % change in the EBIT level.

Key Points

• Financial leverage measures the sensitivity of EPS (Earnings Per Share) with respect to a percentage change in EBIT (Earnings Before Interest and Tax).
• High financial leverage amplifies both gains and losses.

Additional Information

• Financial leverage = EBIT ÷ (EBIT − Interest), and measures how sensitive EPS is to a change in EBIT.
• Borrowing magnifies returns in both directions — the *trading on equity* effect — which is why high leverage raises financial risk.
• Operating leverage = contribution ÷ EBIT, capturing sensitivity to sales; their product is combined leverage.
• A firm with no debt has financial leverage of exactly 1, so EPS moves in step with EBIT.