To achieve the benefts from the use of high financial leverage does a company need to generate a higher level of net income or larger amount of stockholders' equity? I think it is net income...
To determine whether a company can achieve the benefits of high financial leverage by generating a higher level of net income or a larger amount of stockholders' equity, we need to understand the concept of financial leverage and its impact on a company's profitability.
Financial leverage refers to the use of borrowed funds (debt) to finance investments and operations. When a company uses debt to finance its activities, it can potentially magnify its returns, but it also incurs higher financial risk.
The primary benefit of high financial leverage is amplifying returns to shareholders when the return on assets (ROA) exceeds the cost of borrowing. This is known as positive leverage. Positive leverage enhances the company's profitability and can lead to higher net income.
However, the level of stockholders' equity also plays a role in determining the benefits of financial leverage. Stockholders' equity represents the residual claim of shareholders on a company's assets after deducting liabilities. Higher stockholders' equity can provide a cushion against financial risk and increase the confidence of lenders and investors.
So, to achieve the benefits of high financial leverage, a company ideally needs to generate a higher level of net income while maintaining a sufficient amount of stockholders' equity. Generating higher net income shows profitability, while having a larger amount of stockholders' equity indicates financial stability and reduces the company's reliance on debt.
It's important to note that the ideal level of financial leverage varies for each company, and excessive leverage can lead to financial distress if the company is unable to meet its debt obligations. Therefore, companies need to strike a balance between debt and equity financing based on their specific circumstances and the degree of risk they are willing to assume.