CFAI, Volume 2, Reading#24, Page 429.
Solution of Q#5 says that due to higher financial leverage and lower interest coverage Silk road is riskier. I believe higher financial leverage is better.
In general, i think the curriculum revolves around higher financial leverage being bad, all else equal. The idea here is that your debt burden increases, interest expense increases, and risk of excessive loss increases, relative to lower financial leverage.
This is really simplistic, and ignores lots of things (e.g. source of financing, WACC, ROA, proper accounting, etc), but i think it’s what the curriculum is generally geared towards.
Financial leverage =Average total assets/Average shareholders’ equity. Higher financial leverage means assets are in higher proportion as compared to equity. Nothing bad I believe.
Yes for lower interest coverage I do understand that ratio of EBIT is less as compared to Interest paid (interest expense), which may reflect higher risk or weak financial position.
What do you say ro424?
Agreed, but Assets = Liabilities + Equity. So if Assets go up and Equity stays the same (i.e. higher financial leverage) then for the b/s to balance, Liabilities must go up. If those liabilities are long-term debt then your interest expense goes up and your obligations to repay go up. All else equal, you are worse off. Again, this is an oversimplification but i think this is the way the curriculum very generally wants you to understand this.
I think financial leverage is good if it is within a specific benchmark for a specific industry. You can see thhe example in Q4 has a clear benchmark for a good financial leverage as well.
ro424 and Yumi thank you for discussion!
In particular, when debt increases, fixed costs increase, which makes it more difficult to break even, let alone make a profit.