Compiled by Aishwarya Ade
│What is financial leverage?
Financial leverage can be described as the extent to which a business or an investor is utilising the borrowed money. It is a measure of how much a firm uses equity & debt capital to finance its assets. As debt intake increases, so does a company’s financial leverage.
Financial leverage depends on several factors such as: the action of other firms in the industry; and its status as entrant, incumbent or exiting firms in competitive industries. It is important to note that technology, financial structure & risk should be determined together in industries.
Let’s discuss an example to understand the concept of financial leverage.
● A company is formed with a Rs 30 Crore investment from investors (equity capital).
● The company avails debt financing by borrowing Rs 120 Crore, leaving it with a total capital of Rs 150 Crore.
● It can use the total capital of Rs 150 Crore to invest in its business operations & will have more opportunity to further increase company value for its shareholders.
An automaker, for example, could borrow money to build a new factory facility. This new factory would enable the automaker to increase car production and increase profits.
│Why is financial leverage important for firms?
Firms use Debt Capital as a strategy that contributes to magnify shareholder’s value or firm’s wealth maximization.
Undertaking Leverage provides the following benefits to businesses:
│How is financial leverage measured?
One common approach to compute financial leverage is to measure the sensitivity of a firm’s Earnings Per Share (EPS) to a change in its Operating Profit (EBIT). Therefore, a firm’s operating profit should positively increase whenever new debt capital is procured. This is due to the new financial charges associated with new debt capital, that need to be paid by the additional operating profit arising from the use of new debt capital. Otherwise, an unfavourable operating profit will impact the firm’s existence and certainty. It has been observed in different studies that financial leverage has a direct relationship with a firm’s financial performance.
For example, assume Company XYZ reports an EBIT of ₹300 Crore in its first year of operations, an interest expense of ₹70 Crore & has 50 million Outstanding Shares.
We can compute the Company’s Earnings Per Share (EPS) using the following formula:
Company’s resulting EPS would be ₹46 or (₹300 Crore – ₹70 Crore) ÷ 50 million Shares.
In its second year, it reports an EBIT of ₹1000 Crore, an interest expense of ₹120 Crore & outstanding shares of 50 million. It’s resulting EPS will be ₹176 or (₹1000 Crore – ₹120 Crore) ÷ 50 million Shares.
Now having calculated EPS, we can calculate the Company’s Degree of Financial Leverage using the following formula:
Company XYZ’s resulting Degree Of Financial Leverage (DFL) would be 1.21 Or, [(₹176 – ₹46) ÷ ₹46] ÷ [(₹1000 Crore – ₹300 Crore) ÷ ₹300 Crore].
Therefore, if the company’s EBIT increases or decreases by 1%, the DFL indicates its EPS increases or decreases by 1.21%.
│What are the types of risks?
A firm’s risk in general can be divided into Operating risk & Financial risk.
Operating risk is a risk that cannot be avoided since it arises from market uncertainty where the firm undertakes. However, Financial risk is a risk that can be avoided since it arises from variation in earnings per share (EPS) due to use of debt capital as well as the risk of insolvency of the common stock shareholders. Moreover, financial risk is associated with the consequences on uncertainty of firm’s financial policy regarding the debt-equity mix & fixed interest charge associated with debt.
Changes in revenues and changes in economic conditions, operating and financial expenses are few of the several contributing factors to the uncertainty of future cash flows. Introduction of debt capital into a firm’s capital structure intensifies the volatility of earnings per share (EPS). Therefore, additional earnings are vital to compensate for the financial cost arising from the debt capital, otherwise, the employed debt capital will increase the firm’s financial risk.
Operating leverage & financial leverage could either go up or go down with debts depending on the size of the debt elasticity of real capital & contribution margin. Moreover, financial leverage varies due to the adjustment in the underlying interest payments.
│What is the relationship between financial leverage & risk?
By definition, as financial leverage increases, the cash flow requirements necessary to service additional debt also increases. Therefore, the risk of inadequate cash flow is a primary concern in strategic decisions regarding financial structure. This suggests that liquidity & leverage are intricately intertwined in decisions of that kind.
Secondly, the informed strategist must not only consider default risk & the involuntary actions that failure may lead to, but also the priority of claims that attend a given financial structure. In the case of liquidation, be it voluntary or involuntary, shareholders usually hold a claims position subordinate to that of debt holders. Thus increased leverage can have a deteriorating effect on the assets available for distribution to common stock shareholders in the event of liquidation. Therefore, this component of risk enters financial structure decisions as well.
Investment in assets using external funds is a crucial decision, because higher financial leverage due to inefficiency use of debt capital significantly increases financial risk. However, with a higher financial leverage, Return On Equity (ROE) exceeds the Return On Investment (ROI) when the market condition is favourable. It helps firm to keep the financial risk at a lower level. Conversely, a firm having a negative financial leverage will decrease firm’s value as well as a firm’s return & increase the firm’s uncertainty in the future.
This article explained how financial leverage affects & is positively associated with financial risk. A higher level of financial leverage results in a higher level of financial risk because difference between the coefficient of variation of EPS & EBIT is found to be high. Therefore, Firms, should tend to earn additional EBIT to compensate for additional risk arising from the financial decisions. Keeping financial leverage moved over smaller variation is crucial for firms to have a lower level of financial risk.
Financial managers can use this information in developing the firm’s financial policies. For example, non-financial firms can plan how they manage financial risk arising from a lack of risk management or the high debt levels using proper financial management techniques, because business & economic risks are more difficult to hedge as they arise from an environment that is beyond the firm’s control.
Finally, financial leverage can be considered as a determinant of the financial risk. When used properly, financial leverage magnifies returns on committed funds.