Financial Leverage
Financial leverage can be defined as the degree to which a company uses fixed-income securities, such as debt and preferred equity. With a high degree of financial leverage come high interest payments. As a result, the bottom-line earnings per share is negatively affected by interest payments. As interest payments increase as a result of increased financial leverage, EPS is driven lower.
As mentioned previously, financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.
Degree of Financial Leverage
This measures the percentage change in earnings per share over the percentage change in EBIT. This is known as "degree of financial leverage" (DFL). It is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.
- DFL = % Change in EPS ÷ % Change in EBIT.
A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be equal to 1.
There is a reasonable assumption about the absence of any changes in accounting policy which would make the EPS and EBIT figures incomparable from the previous years
Example: Degree of Financial Leverage
With Newco's current production, its sales is $7 million annually. The company's variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annual interest expense amounts to $100,000 annually. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?
Answer: The Company’s DFL is calculated as follows:
- DFL = ($7,000,000-$2,800,000-$2,400,000) / ($7,000,000-$2,800,000-$2,400,000-$100,000)
- DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase 21.2%.
Example Profit Magnification
The best example of degree of financial leverage is in the field of home ownership. Let’s say that you brought a house for Rs 100. It is financed 30% by own money and 70% by debt bearing interest of 10%. Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Let’s say that the price of the house went up by 20% to 120. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 43. Since your original investment was Rs 30, you have gained Rs 13. A price increase of 20% has led to an increase in the shareholders return by approximately 43%!
Loss Magnification Example
Let’s say that you brought the same house for Rs 100. It is financed 30% by own money and 70% by debt bearing interest of 10%. Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Let’s say that the price of the house went down by 20% to Rs 80. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 3. Since your original investment was Rs 30, you have lost Rs 27. A price decrease of 20% has led to a decrease in the shareholders return by approximately 90%
Interpretation: Leverage is very dangerous unless the company is reasonably certain of its earnings. Investors view the leverage ratio with great detail. This is because it enables a small change in the EBIT to completely wipe out the company’s capital and make it insolvent almost overnight.
Degree of Operating Leverage Ratio
The degree of operating leverage of a company is very important from an investor’s standpoint. Although it shows the riskiness of a venture, it also shows the efficiency of a company. Just like, financial leverage arises out of the capital structure of a company; operating leverage arises out of its cost structure. If a company has too many expenses which are fixed in nature, the company is said to have high operating leverage. Typically, companies that are highly mechanized have high operating leverage. This is because they have replaced labor which is a variable cost by depreciation on machinery which is a fixed cost.
This creates debate whether having a high operating leverage is a bad thing. Henry Ford was amongst the first to use operational leverage on a large scale and build cars at a fraction of what it would cost earlier. This idea was soon followed by many others and high operating leverage became the norm.
Formula
- Degree of Financial Leverage = % Change in Sales / % Change In EBIT
The ratio makes a reasonable assumption that accounting policies have not changed so much that the Sales and EBIT figures do not remain comparable across companies or across time.
Example
Profit Magnification Example
In case a company has a high operating leverage, most of its costs are fixed. Consider for example, the movie business. The costs incurred to make the movie are fixed. Hence when tickets are sold, the first few tickets go towards recovery of the cost of production. However, once a breakeven point has been reached, entirely all the money goes towards the bottom line. Hence a slight change in sales has the capability to magnify and bring about a big change in EBIT.
Loss Magnification Example
However, every lever has its flipside and operating leverage is no exception. Since most of the costs are fixed, in the event of a downturn, the company does not have the opportunity to cut costs. In many cases, companies are not able to fulfil their requirements to meet the fixed cost obligation. Whereas all companies are hurt in the event of a downturn, companies with excessively high operating leverage are wiped out in such events.
Interpretation: Whether operating leverage is good or bad for a company depends on the nature of its operations and stability of its cash flow streams. In case of stable operations, high operational leverage in desirable and even recommended.
Degree of Combined Leverage Ratio
Most firms use both operating leverage and capital leverage to some extent. In today’s business world it is almost impossible to run a business without having some degree of automation and mechanization (operating leverage). It is also not possible to grow at an adequate speed unless the company is taking advantage of borrowed money. However, the degree to which a company uses operating leverage and financial leverage can be different. Some companies use more financial leverage than operating leverage while other use more operating leverage. This creates a challenging scenario whereas an analyst has to interpret the different degrees of riskiness of companies with different cost and capital structures. The degree of combined leverage (DCL) makes it possible to do this.
Companies with different cost and capital structures. The degree of combined leverage (DCL) makes it possible to do this.
Formula
- Degree of Combined Leverage = %Change in EPS / %Change in Sales
- Degree of Combined Leverage = Degree of Operating Leverage * Degree of Financial Leverage
Example
Therefore, if operating leverage of a firm= 1.4 whereas financial leverage = 2, then the degree of combined leverage equals 1.4*2 = 2.8.
Interpretation: Degree of operating leverage shows how a change in sales affects the EBIDTA of the firm. Whereas degree of financial leverage shows how a change in EBIDTA affects the EPS of the firm. Combining the two analysts can predict how a change in sales is likely to magnify the gains or losses to the EPS.
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