What does financial leverage measure?
Last updated Jun 24, 2026
Correct Answer:
Option C —
The sensibility of EPS w.r.t% change in the EBIT level
Financial Leverage measures the relationship between a company's Earnings Before Interest and Taxes (EBIT) and its Earnings Per Share (EPS). It specifically evaluates how sensitive the earnings available to shareholders are to fluctuations in operating income.Fixed Financial Costs: It exists when a company uses "fixed-cost" sources of funds, such as debt (which requires interest payments) or preference shares (which require fixed dividends).
The Magnification Effect: Because interest is a fixed cost, a small percentage change in EBIT results in a disproportionately larger percentage change in EPS. This is known as the "trading on equity" effect.
Why other options are incorrect:
A) No change with EBIT and EPS: This is incorrect because leverage by definition implies a relationship and change between these two variables.
B) The sensibility of EBIT with % change with respect to output: This describes Operating Leverage, which measures how sales/output volume affects operating income (EBIT).
D) % variation in the level of production: This refers to production efficiency or capacity utilization, not financial risk or leverage.
Answer verified by Quintessence Classes faculty — Karan Nagar, Srinagar.
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