The Degree of Financial Leverage as a Determinant of Financial Risk: An Empirical Study of Colombo Stock Market in Sri Lanka

Abstract

The decision to involve in the financial market is more complicated due to correct decisions will make a return for the firm and wrong decisions will hurt the firm. A knowledge on how well the firm has used the total assets with comparison to how they were financed of the market is magnitude for financial managers as well as investor to make strategic decisions in the market. This study investigates the relationship between the degree of financial leverage and financial risk with the explanatory variables, firm size effect and industry effect, in different industries of Sri Lanka. The study was based on fifteen companies over six years for the period from 2006 to 2011 in Hotels and Travels, and Chemicals and Pharmaceuticals industry of the Colombo Stock Exchange in Sri Lanka. The findings of the study revealed that the degree of financial leverage has a significant positive correlation with financial risk. And also, the industry effect significantly affects to the financial risk. However, firm size does not significantly affect the financial risk. In addition, the degree of financial leverage can be considered as a determinant of financial risk for managers and investors in determining their investment in a company, an industry or a market. The study also provided valuable insights that financial managers and investors could utilize to develop more focused finance and investment strategies, which may enable them to gain an optimal return in an increasingly competitive market setting.