FINANCIAL LEVERAGE

By- Preetesh anand E-mailpreetesh6845@gmail.com

Leaver means use of forces to lift or move an object of great weight, which otherwise will require much more force. A company can finance its assets by debt or equity. Company can also use preference capital. The rate of interest on debt is fixed irrespective of companies return on assets. The company has legal binding to pay interest on debt. The rate of preference dividend is also fixed but the same will be paid if the company earns profit.

The ordinary shareholders are entitled to a share out of what is left out after paying these. They will get out of what is left out after paying these. They will get out of the earning after interest and taxes and after paying the preference dividend. From the financial angle the leverage means effect, which the fixed charge securities like debt, debenture or preference shares produces on return.

Example:-

ABC Ltd. Wanted to purchase fixed assets worth Rs. 80 lacs for the execution of a project The company has a number of options for financing its project. For the sake of simplicity we take two options as: Rising entire Rs. 80 lacs as equity Raising Rs. 30 lacs as equity capital and Rs. 50 lacs as debt @18%

The company is required to pay dividend @20% to equity shareholders as other companies of this type were paying this much return and investors will subscribe to their shares only if they hope to get this much return. The taxation rate for the company is 40%. The earning power of ABC Ltd. Is 40%( before taxes and interest).

The calculations as follows:Rs. 80 lacs as share capital Earning on assets of Rs. 32 80 lacs @40% Less Interest : 18% on Rs. 50 lacs Earning after Interest 32 Taxes @ 40 % Earning after taxes 12.8 19.2 Rs. 30 lacs as sharecapital plus Rs. 50 lacs as debt @ 18% 32 9 23 9.20 13.80 46%

Earning after interest 24% and taxes as % of share capital

If we analysis the result it is seen that the net return on equity is 24% when no debt is used but it is 46% when debt is used. The use of debt has lifted the return to the shareholders because the interest which the company paid on debt is an expense and therefore reduces the profit and consequently the taxes gets reduced. The profit is to be distributed to less number of shareholders.

Example:- 2

Supposing in the above example the earning power of ABC Ltd. Is only 15%.

Solution will be:Rs. 80 lacs as share capital Rs. 30 lacs as sharecapital plus Rs. 50 lacs as debt @ 18% 12 9 3

Earning on assets of Rs. 80 lacs @15% Less Interest : 18% on Rs. 50 lacs Earning after Interest

12 12

Taxes @40%
Earning after taxes Earning after interest and taxes as % of share capital

4.8
7.2 9

1.20
1.8 6

In the above case the use of debt has reduced the earning % of shareholders. Why?

In this case the earning power (15%) of the company is less than the cost of debt (18%), therefore the return to the shareholder has been reduced as the company has not able to earn the cost of debt.

It implies that the financial leverage can increase the return to shareholders and also reduce it depending on the earning power of the company. It is a double-edged sword. The lower the interest rate, the greater will be the profit, and less the chance of loss. The less the amount borrowed the lower will be the profit or loss also greater the greater the risk of unprofitable leverage and also the greater the chance of gain.

Measure of financial leverage

The most commonly used measures of financial leverage are: 1. Debt assets Ratio

2. Debt equity Ratio

3. Interest coverage

Debt- assets Ratio

It is the ratio of debt to total capital

L1 =

Debt Total capital

D D+s

Where, D is value of equity, S is value of equity i.e.,

paid up capital and reserves. The paid up capital and reserves can be measured at market values, but since market values are difficult to obtain and there is wide fluctuations and in the case of new undertakings it is not available therefore we use only book value.

Debt- equity Ratio

It is the ratio of debt to equity

L2 =

Debt Equity

D S

Interest coverage
It is the ratio of net operating income ( or EBIT) to interest charges

L3 =

Net operating income = Interest

EBIT Interest

Bharat Engines Limited plans to acquire total assets amounting to 100 Lacs. The company has only two sources of finance viz, debt and equity. The chairman wants to know the changes that will take place in the debt equity and debt assets ratio for various debt levels.
Debt (Rs. Lacs) D Zero 10 20 30 50 80 100 Equity (Rs. Lacs) S 100 90 80 70 50 20 Zero Debt assets Ratio D/S+D Zero 10% 20% 30% 50% 80% 100% Debt equity Ratio D/S 100 11.1% 25% 43% 100% 400%

If we analyse the last two columns above we observe that:-

The Debt assets ratio rises at a constant rate and reaches a maximum of 100%. The debt equity ratio grows exponentially and reaches infinity (a) The two ratios are mathematically related and can be derived from each other L2 D/S D L1 = = = 1+ L2 1+D/S V

L1

D/V

L2 =
1 - L1

=
1 D/V

=
S

The use of these formulas for deriving one ratio from other can be demonstrated any level. For example, at debt level of Rs. 80 lacs the debt assets ratio is 80%. The debt equity ratio can be calculated as following:
L1 L2 = 1- L1 = 1- 80 80 = 20 80 = 400%

The relation indicate that both measures of financial leverage will rank companies in same order.

However the first measure ( i.e., D/V ) is more specific and its value ranges from zero to one. Zero means no debt while one means 100% debt and no equity. The value of second measure ( i.e., D/S ) varies from zero to any large number. The debt equity ratio as a measure of financial leverage, is more popular in practice. This ratio is not fixed as such but it is generally compared with the industrys standard. The company will be considered risky if the debt equity ratio exceeds the industry standard. The first two measures are also measures of capital gearing. They show the borrowing position of company at a point of time, but they fail to measure the level of financial risk.

Financial risk means the possible failure of the company to pay interest and the principle debt. It is the third measure commonly known as coverage ratio show the capacity of the company to meet the financial charges
The companys coverage ratio is compared with the industrys standard.

This measure suffers from the following limitations:1. To determine the companys capacity to pay fixed charges, it is the cash flow information, which is relevant, not the earning. 2. This ratio when calculated on past earning does not provide any guide regarding the future riskiness of the company. 3. It is only a measure of short term liquidity than of leverage.

Financial leverage and shareholders return:-

What is the purpose of financial leverage?

Financial leverage increase the risk of the company still the management is interested to do that. Why?

The obvious answer is to increase the return of the shareholders. Return of the shareholders will increase only when the fixed charges funds i.e., loans/ debenture/ bonds etc have a cost lower than the firms rate of return on net assets. Thus when the difference between the earning generated by assets financed by fixed charges funds and cost of these funds is distributed to the shareholders. The earning per share (EPS) or return on equity increases. However, EPS, ROI will fall if the cost of fixed charge funds is higher than the rate of return on the firms assets. It should always kept in mind that EPS, ROE, and ROI are important figure for analyzing the impact of financial leverage.

Degree of financial leverage:The degree of financial leverage is defined as the percentage change in EPS due to given change in EBIT. % change in EPS DFL = % change in EBIT

Change in EPS/EPS Or, DFL = Change in EBIT/EBIT

Operating leverage
The operating leverage menace use of fixed assets in operation of a firm. A firm will not have any operating leverage if its ratio of fixed cost to total cost is nil. For such a firm a given change in sales would produce the same percentage change in operating profits or in EBIT. If a firm has fixed cost, it would have operating leverage and the percentage change in operating profit would be more for a given change in sales. If a firms total cost has higher percentage of fixed costs, it will have higher percentage of operating leverage.

In the case of highly leveraged company ( i.e., having higher % of fixed cost to total cost ), the operating profit will increase at a faster rate for any given increase in sales. However if the sales fall, this firm will suffer more loss than the firm with no or less operating leverage. Operating leverage is double edged sword. It may increase the profit at higher rate and at the same time can reduce the profit at higher rate.

Example:Let us suppose that the firm Y and Z manufacture the same product
Firm Y Selling Price Fixed cost Rs. 8 per unit Rs. 80000 Firm Z Rs. 8 per unit Rs. 200000

Variable cost

Rs. 6

Rs. 4

What are the profit earned by the firms, if the sales range from 20,000 to 80,000?

Firm Y
Sales Rs. (000) 20 30 160 240 Variable cost Rs. (000) 120 180 Fixed cost Rs. (000) 80 80 Total Cost Rs. (000) 200 260 EBIT Rs. (000) -40 -20

40
50 60 70 80

320
400 480 560 640

240
300 360 420 480

80
80 80 80 80

320
380 440 500 560

0
20 40 60 80

Firm Z
Sales Rs. (000) 20 30 160 240 Variable cost Rs. (000) 80 120 Fixed cost Rs. (000) 200 200 Total Cost Rs. (000) 280 320 EBIT Rs. (000) -120 -80

40
50 60 70 80

320
400 480 560 640

160
200 240 280 320

200
200 200 200 200

360
400 440 480 520

-40
0 40 80 120

Firm Y
fixed cost Break even point (BEP) = Sales- variable cost = 86 80000 =40000

Firm Z
fixed cost Break even point (BEP) = Sales- variable cost = 84 200000 =50000

Break even point is that volume of sales in unit at which there is no profit or loss. At a sales level above break even point sales there will be profit and at the sales level less that the break even sales there will be loss. Firm Z with high ratio cost is having high operating leverage. Therefore for firm Z at lower sales the loss is more and at higher sales the profit is more.

Degree of operating leverage:-

The degree of operating leverage is the percentage change in operating profit resulting from percentage change in sales. % change in operating profit DOL = % change in sales Change in EBIT = EBIT divided by sales change in sales

For firm Z, when sales increases from 70000 units to 80000 units, then the DOL at 70000 is as follows 120000 80000 DOL = 80000 = 3.5 divided by 560000 640000 560000

The DOL of 3.5 indicates that if sales increases by 100%, operating profit will increase by 350%. For firm Y, which employs less fixed cost, DOL is 2.33.

Firm Ys operating profit will increase by 233% if its sales increase by 100%. An alternate formula for calculating DOL is as follows: DOL = = Q(sv)F contribution / EBIT Q(sv)

Where Q is quantity of output, and s is selling price, v is unit variable cost and F is total fixed cost
For Firm Z 70000 ( 8 4 ) DOL = 70000 ( 8- 4 ) 200000 = 80000 280000 = 3.5

THANK YOU