Financial Leverage
Financial leverage refers to the extent to which a company uses fixed-income securities such as debt and preferred equity to finance its operations. A higher degree of financial leverage results in higher interest obligations. Consequently, increased interest payments reduce the company’s net income and negatively impact Earnings Per Share (EPS). When leverage rises, the risk of declining EPS also increases.
Financial risk arises from the use of debt and preferred equity in the capital structure. As a firm increases its reliance on borrowed funds, fixed interest payments rise. If the company fails to generate sufficient revenue to cover these payments, shareholders face greater risk due to the potential reduction in returns. Therefore, a company must carefully consider its optimal capital structure when making financing decisions to ensure that additional debt enhances overall firm value rather than diminishes it.
Financial leverage can also be described as the firm’s ability to use fixed financial costs to magnify the effect of changes in Earnings Before Interest and Taxes (EBIT) on the company’s EPS. This concept is sometimes referred to as “Trading on Equity.”
Definitions of Leverage
- Van Horne: “Leverage refers to the use of fixed costs in an attempt to increase (or lever up) profitability.”
- Ezra Solomon: “Leverage is the ratio of net returns on shareholders’ equity to the net rate of return on total capitalisation.”
- S.C. Kuchhal: “The term leverage is used to describe a firm’s ability to use fixed-cost assets or funds to magnify the return to its owners.”
Types of Risk
- Business Risk - Business risk is the inherent risk associated with a firm’s day-to-day operations. Although it cannot be eliminated entirely, it can be mitigated through effective management and timely decision-making. According to Brigham: “Conceptually, the firm has a certain amount of risk inherent in its operations this is its business risk.”
- Financial Risk - Financial risk arises from the presence of debt in the capital structure. Regardless of the firm’s performance, it must pay a fixed amount of interest to creditors. As the level of debt increases, the firm’s obligation to meet these payments also increases. If the firm cannot generate adequate revenue to meet interest payments, it becomes exposed to higher financial risk.
Degree of Financial Leverage (DFL)
The Degree of Financial Leverage (DFL) measures the percentage change in Earnings Per Share (EPS) resulting from a given percentage change in Earnings Before Interest and Tax (EBIT). It reflects how sensitive EPS is to changes in EBIT due to the presence of fixed financial costs such as interest.
Formula:
A useful shortcut is:
If interest = 0, then DFL = 1, because in the absence of financial leverage, changes in EBIT directly translate to equal changes in EPS.
This measure assumes that no significant changes in accounting policies have occurred that would make EPS and EBIT figures inconsistent with previous years.
Example: Calculating DFL
Scenario:
- Newco’s current annual sales = $7 million
- Variable cost ratio = 40%
- Fixed operating costs = $2.4 million
- Annual interest expense = $100,000
Step 1: Calculate EBIT
Step 2: Calculate EBIT after interest
Step 3: Compute DFL
Interpretation:
If EBIT increases by 20%, EPS will increase by:
Examples of Leverage Effects
A. Profit Magnification Example
You buy a house for ₹100, financing:
- 30% equity = ₹30
- 70% debt = ₹70, at 10% interest = ₹7
- If the house price rises 20%, new value = ₹120.
- After repaying creditors: 120-77=43
Your gain on investment: 43-30=13
Return on equity: 13/30≈43%
A 20% price increase results in a 43% return for the equity holder.
B. Loss Magnification Example
- Using the same financing structure:
- If the house price falls 20%, new value = ₹80.
- After repaying creditors: 80-77=3
- Your loss on investment: 30-3=27
- Return on equity: (-27)/30=-90%
A 20% price decrease results in a 90% loss for the equity holder.
Interpretation
Leverage amplifies both profits and losses. While it can significantly boost returns in favourable conditions, it also increases the firm’s financial risk. Even a small decline in EBIT can erode equity rapidly, potentially leading to insolvency.
Therefore, investors closely examine leverage ratios to assess the risk level of a company. Leverage should only be used when the firm has high certainty of stable or rising earnings.
Degree of Operating Leverage (DOL)
The Degree of Operating Leverage (DOL) is a key indicator used by investors to assess a company’s operating risk and efficiency. Operating leverage arises from a firm's cost structure, particularly the proportion of fixed costs relative to variable costs.
A company with a high proportion of fixed costs (such as depreciation on machinery) compared to variable costs is said to have high operating leverage. Industries with heavy mechanization like automobile manufacturing, steel, aviation, or software typically exhibit high operating leverage because machinery and technology replace labor, converting variable costs into fixed costs.
This raises an important question:
Is high operating leverage good or bad?
Historically, industrial pioneers like Henry Ford showed that high operating leverage can significantly reduce production costs and improve efficiency. This concept has since become a standard practice across many industries.
Formula
This formula assumes that no significant accounting policy changes have occurred that would affect the comparability of Sales and EBIT across different years or companies.
Examples
A. Profit Magnification Example
Companies with high operating leverage have mostly fixed costs.
A great example is the movie industry:
- The cost of producing a film is almost entirely fixed.
- Initial ticket sales help recover these fixed production costs.
- Once the break-even point is crossed, every additional ticket sale contributes almost entirely to profit.
Thus, even a small increase in sales can cause a significant jump in EBIT, demonstrating the magnifying effect of high operating leverage.
B. Loss Magnification Example
The same leverage that magnifies profits also magnifies losses. When fixed costs are high, companies cannot easily scale down costs during a downturn. If sales drop:
- Revenue falls sharply
- But fixed costs remain unchanged
- EBIT can decline drastically
- Companies with extremely high operating leverage may even fail to meet fixed cost obligations
During recessions or economic downturns, such firms are more vulnerable than those with flexible, variable cost structures.
Interpretation
Whether high operating leverage is beneficial depends on the nature of the business and the stability of cash flows:
- Stable and predictable demand ➝ High operating leverage is advantageous, as it boosts profitability through economies of scale.
- Volatile or unpredictable demand ➝ High operating leverage becomes risky, as fixed costs remain constant even when sales decline.
In summary, high operating leverage can be powerful but must be managed carefully depending on the industry and market conditions.
Degree of Combined Leverage (DCL)
Most companies utilize both operating leverage and financial leverage to some degree. In the modern business environment:
- Operating leverage is unavoidable due to automation, technology, and mechanization.
- Financial leverage is essential for achieving growth through borrowed funds.
However, the extent to which firms use these two types of leverage varies significantly. Some firms rely heavily on debt (high financial leverage), while others depend more on fixed operating costs (high operating leverage). This variation creates difficulty for analysts trying to compare the overall risk profiles of different companies.
The Degree of Combined Leverage (DCL) simplifies this comparison by capturing the combined effect of both operating and financial leverage on a company’s earnings.
Formula
Primary Formula
Relationship Formula
Example
If a company has:
- Degree of Operating Leverage (DOL) = 1.4
- Degree of Financial Leverage (DFL) = 2
Then: DCL = 1.4×2=2.8
This means a 1% change in sales will result in a 2.8% change in EPS.
Interpretation
- DOL measures how changes in sales impact EBIT (or EBITDA).
- DFL measures how changes in EBIT impact EPS.
By combining these two, DCL shows the total effect of sales changes on EPS.
A higher DCL indicates:
- Greater sensitivity of EPS to changes in sales
- Higher potential returns in good conditions
- Higher risk in downturns, as EPS may decline sharply
Thus, DCL helps analysts assess the overall risk and reward dynamics stemming from both cost structure and capital structure.
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