FINANCIAL LEVERAGE RISK: A NEW METHODOLOGICAL APPROACH

Financial leverage or gearing belongs to the most common concepts widely used both in the theory of finance and in business practice. Unfortunately, this concept is not unambiguously defined. There are many methods of measuring the leverage, some of them being contradictory to each other. The paper gives a brief review of the literature on the subject, which shows the conceptual chaos around the meaning of this term, and it presents author's own definition of the risk related to the financial leverage. The definition is based on the folded cumulative distribution function and it interprets the risk as an increased probability of obtaining extreme ROE values after incurring debt. The proposed definition is a generalization of partial concepts applied in the literature. Its main merit is a flexibility, which allows for different interpretation of the parameters concerned. The author also presents a simulation to illustrate the amount of risk generated by the financial leverage.