Financial Leverage
February 5, 2019 By Prachi M Leave a Comment
Definition: Financial leverage refers to the utilization of borrowed funds to
acquire new assets which are assumed to generate a higher capital gain or
income as compared to the cost of borrowing. It is a liability for the borrowing
business organization whereas, makes a source of income for the lender.
The three ways in which the company can obtain funds are as follows:
Debt: Debts are the funds borrowed in the form of bonds, commercial
papers and debentures to be paid back to the lender with interest.
Equity: Equity is the issuing of shares to the public for gathering funds
by giving ownership.
Leases: Lease refers to a legal agreement abiding to which the lessor
provides a property to be used by the lessee for the defined period in
exchange for money.
Content: Financial Leverage
1. Factors
2. Measures
3. Debt-Equity Ratio
4. Debt Ratio
5. Interest Coverage Ratio
6. Degree of Financial Leverage (DFL)
7. Example
8. Solution
9. Benefits
10. Limitations
11. Conclusion
Factors Affecting Financial Leverage
Financial leverage is more about the borrowings from external sources and
needs to be repaid sooner or later. To understand more about financial
leverage, let us go through the following factors:
Second Stage Leverage: The financial leverage is considered as
second stage leverage because it is dependant upon the degree of
operating leverage. If the operating risk is high, the company will plan for
low financial leverage and vice-versa.
Financial Liability: The borrowings in the form of debts create
financial liability on the company.
Financing Decision: The financial leverage decision is a part of the
company’s financing strategy planned by the directors.
Interest Rates: These borrowings are usually payable with interest
which is quite high.
Stability of the Firm: The most important factor considered by the
management while taking the financing decision is the firm’s position
and balance, to bear the risk.
Return on Assets: The returns which the additional capital needs to
be estimated to find out whether the company will be able to generate
higher profits on the capital employed or not.
Fixed Financial Cost: The debts create a fixed financial burden in the
form of interest over the company.
Measures of Financial Leverage
After employing additional capital into the business, the management uses
various financial ratios to the performance of the company. The four most
crucial financial leverage ratios or measures are given below:
Debt-Equity Ratio
The debt-equity ratio is the proportion of the funds which the company has
borrowed to the fund raised from shareholders. In short, it is the ratio of the
borrowings to the owner’s fund.
Analysis: The higher the debt-equity ratio is, the weaker is the financial
position of the company. Therefore, this ratio should always be less to avoid
the risk of bankruptcy and insolvency.
Debt Ratio
The debt ratio determines the company’s asset position or strength to meet its
liabilities.
Analysis: Lower is the debt ratio of the company; the sounder is its financial
position, indicating that the company has sufficient assets to pay of the
liabilities at the time of downfall.
Interest Coverage Ratio
The interest coverage ratio emphasizes the company’s ability to pay off the
interest with the profits earned.
Analysis: If the ratio is high, it signifies that the company can make enough
profit to pay the interest due and vice-versa.
Degree of Financial Leverage (DFL)
The degree of financial leverage (DFL) signifies the level of volatility in the
earning per share (EPS) with the change in operating income as a result of the
capital restructuring, i.e., acquisition of debts, issuing of shares and
debentures and leasing out assets.
Where,
Percentage Change in EPS = [(New EPS – Old EPS)/Old EPS]
EPS stands for earning per share
Percentage Change in EBIT = [(New EBIT – Old EBIT)/Old EBIT]
EBIT stands for earnings before interests and taxes
Analysis: A higher DFL indicates that the company is more sensitive to the
change in operating income, ultimately showing its unstable earnings per
share.
Example
ABC Ltd. expanded its business unit by investing $200000 out of which
$50000 was acquired through debts. The company issued 1500 equity shares
of $100 each for the remaining amount. The company generates a profit
before interests and taxes of $20000 annually. The total assets amounted to
$145000, and the liabilities were $75000. The interest payment is $5000.
The previous year’s earning per share (EPS) was $3.5, and in the current
financial year, the EPS is $4.8, if the last year’s EBIT is $8000. Find out the
related financial leverage ratios.
Solution
Debt Equity Ratio = Total Debt/Shareholder’s Equity
Debt Equity Ratio = 50000/150000
Debt Equity Ratio = 0.33
Debt Ratio = Liabilities / Assets
Debt Ratio = 145000/75000
Debt Ratio = 1.93
Interest Coverage Ratio = EBIT / Interest Expenses
Interest Coverage Ratio = 20000/5000
Interest Coverage Ratio = 4
Degree of Financial Leverage (DFL) = Percentage Change in
EPS/Percentage Change in EBIT
Percentage Change in EPS = [(New EPS – Old EPS)/Old EPS] ⨯ 100
Percentage Change in EPS = [(4.8 – 3.5)/3.5] ⨯ 100
Percentage Change in EPS = 37%
Percentage Change in EBIT = [(New EBIT – Old EBIT)/Old EBIT] ⨯ 100
Percentage Change in EBIT = [(20000 – 8000)/8000] ⨯ 100
Percentage Change in EBIT = 150%
Degree of Financial Leverage (DFL) = 37/150
Degree of Financial Leverage (DFL) = 0.25
Benefits of Financial Leverage
The financial leverage has various advantages to the company, management,
investors and financial companies. The following are some such benefits:
Economies of Scale: The financial leverage helps the organizations to
expand its production unit and manufacture goods on a large scale,
reducing the fixed cost drastically.
Improves Credit Rating: If the company take debts and can pay off
these debts on time by generating a good profit from the funds availed, it
secures a high credit rating and considered reliable by the lenders.
Favourable Cash Flow Position: This additional capital provides an
opportunity to increase the earning power of the company and hence to
improve the cash flow position of the company.
Increases Shareholders’ Profitability: As the company expands its
business through financial leverage, the scope for profitability also
increases.
Tax Relaxation: When the debts and liabilities burden the company,
the government allows tax exemptions and benefits to it.
Expansion of Business Ventures: The need for financial leverage
arises when the company plans for growth and development, which is a
positive step.
Limitations of Financial Leverage
There are certain drawbacks of the financial leverage which are mainly related
to borrowings through debts. These are as follows:
High Risk: There is always a risk of loss or failure in generating the
expected returns along with the burden of paying interest on debts.
Adverse Results: The outcome of such borrowings may be harmful at
times if the business plan goes wrong.
Restrictions from Financial Institutions: The lending financial
institution usually restricts and controls the business operations to some
extent.
High Rate of Interest: The interest rates on the borrowed sum is
generally high, which creates a burden on the company.
Benefits Limited to Stable Companies: The financial leverage is a
suitable option for only those companies which are stable and possess a
sound financial position.
May Lead to Bankruptcy: In case of unexpected loss or poor returns
and huge debts or liabilities, the company may face the situation of
bankruptcy.
Conclusion
A company must be careful while analyzing its financial leverage position
because high leverage means high debts. Also, giving ownership may prove
to be hazardous for the organization and even result in huge loss and business
failure.
