An Investigation into the Relationship between Degree of Financial Leverage and Financial Risk of Firms: A Comparative Study between Listed MNCs and Domestic Companies of Bangladesh

Abstract

Financial leverage can be defined as the degree to which a company uses debt financing rather than equity financing to magnify earnings of shareholders. It not only can boost a company's returns, but also it increases financial risk. The main objective of the study is to analyze the relationship between degree of financial leverage and financial risk of DSE-listed MNCs & domestic companies of Bangladesh over a 20-year period (1996-2015). The study was based on secondary data. Seven companies from each of the two populations (MNCs and domestic companies) were selected as sample from six industrial sectors. Measures of financial risk are coefficient of variation and mean absolute deviation of EPS to EBIT [FLR (CV) & FLR (MAD)]. Three measures of degree of financial leverage was used; capital structure [DFL (CS)], financing cost structure [DFL(FS)] and general measure [DFL(Gen)]. It was found that average FLR (CV) and FLR (MAD) of domestic companies were 0.804 and 0.832 respectively and that of MNCs were 0.530 and 0.607 respectively. DFLs of domestic companies are higher than that of MNCs in all three measures of DFL in all the years. In case of domestic companies, none of the correlation coefficient between DFL and FLR is significant at 5% significance level. In case of MNCs, correlation coefficient between DFL (FS) and FLR is significant at 5% level. MNCs show comparatively stronger positive relationship between DFL (FS) and FLR as well as between DFL (Gen.) and FLR. On the other hand, domestic companies show comparatively stronger positive relationship between DFL (CS) and FLR. Both types of firms have very less amount of debt in their capital structure which results in less financial risk. Considering the profitability, both types of firms are capable to raise more debt capital to gain financial leverage advantage and to reduce cost of financing.