Financial leverage

Financial leverage is the relationship between operating profit and EPS (earnings per share). In short, it measures the level of debt. It is a measure of how the potential use of fixed financial costs (e.g. interest on debt) can enlarge the effect that change in operating profit (EBIT) has on EPS (earnings per share).

When does a firm have financial leverage?

If a firm has mixed financial costs, it has financial leverage. Due to financial leverage (existence of fixed financial costs), any increase in EBIT will result in even larger increases in EPS and any decrease in EBIT will result in even larger decreases in EPS.

How to calculate degree of financial leverage (DFL) of the firm?

To calculate degree of financial leverage, which is just a way to measure financial leverage of the firm, we can follow the following formula:

DFL =% change in EPS/% change in EBIT

Therefore, if the degree of financial leverage is greater than 1, then financial leverage exists (which is the case as long as the company has fixed financial costs). Also, any increase in financial leverage results in an increase in risk and any decrease in financial leverage results in a decrease in risk.

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Operating leverage

Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that change in sales volume has on operating profit (EBIT).

We can represent the calculation of operating leverage as follows:

Sales (P * Q)

Less: Fixed operating costs (FC)

Less: Variable operating costs (VC*Q)

= EBIT

Or

EBIT = (P*Q)-FC-(VC*Q)

This simplifies into:

EBIT = Q * (P-VC) – FC

When do firms have operating leverage?

If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.

Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.

How to calculate the degree of operating leverage (DOL) of the firm?

To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:

DOL =% change in EBIT/% change in sales

Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).

Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.

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Leverage

In finance, leverage (which is also called gearing or levering) refers to the use of debt rather than equity as a source of capital to finance investments and reinvestments. The more debt the business uses the more leverage it has.

As leverage increases, the risks also increase and so does the return on investment. However, as leverage decreases, the risks also decrease as well as the return on investment. Management have almost total control over the risk introduced by increased leverage.

There are three types of leverage:

  • Operating leverage – refers to the relationship between sales revenue and operating profit (which is also called EBIT (earnings before interest and taxes))
  • Financial leverage – refers to the relationship between operating profit and EPS (earnings per share)
  • Combined or total leverage – refers to the relationship between sales revenue and EPS

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EBIT-EPS Capital Structure Approach

The EBIT-EPS capital structure approach focuses on finding a capital structure with the highest EPS (earnings per share) over the expected range of EBIT (earnings before interest and taxes).

The reason why we are interested in finding a capital structure which will permit maximization of the EPS over the expected range of EBIT is because it partially helps us to achieve the ultimate objective of the enterprise. The ultimate objective of the enterprise is to maximize shareholders’ wealth by maximizing its stock price. Two key variables that affect stock price are return (earnings attributed to owners of the enterprise) and risk (which can be measured by required return (rs)). This approach explicitly considers maximization of returns (EPS). However, it is important to note that this approach ignores risk (does not explicitly consider risk).

Major shortcoming of the EBIT-EPS approach


The fact that this approach fails to explicitly consider risk is the major shortcoming of this method. As firm obtains more debt (its financial leverage increases), the risk also increases and shareholders will require higher returns to compensate for the increased financial risk. Therefore, this approach is not completely appropriate because it does not consider one of the key variables (risk), which is necessary for maximization of shareholders’ wealth.

Considering financial risk


As per above, the approach does not explicitly consider financial risk. However, when utilizing the approach, financial risk can be considered in two ways:

1) The approach measures financial risk by the financial breakeven point. The higher the breakeven point the greater the financial risk.

2) The approach also measures the financial risk by the slope of the capital structure line. The steeper the capital structure line the greater the financial risk.

EBIT-EPS graph


It is a graphical approach. EPS is plotted on the vertical axis (x-axis) and EBIT on the horizontal axis (y-axis). By connecting the coordinates for different capital structures (different variations of equity versus debt), capital structure lines for each capital structure are graphed.

We will need to represent EBIT-EPS coordinates (capital structure lines) for different capital structures to ascertain at which levels of EBIT which capital structure is preferred. This will allow us to find a capital structure with the highest EPS over the expected range of EBIT.

For the purposes of this article it is sufficient to mention that to find EBIT-EPS coordinates we can assume particular EBIT values (and associated earnings available for common stockholders values) and calculate EPS in line with such values for different capital structures.

The formula to calculate EPS is as follows:

EPS = Earnings Available for Common Stockholders/ Number of Shares of Common Stock Outstanding Another easy way to find one of the EBIT-EPS coordinates is to use the financial breakeven point calculation. Financial break-even point occurs at the level of EBIT (earnings before interest and taxes) at which EPS (earnings per share) equals zero. At this level of EBIT all fixed financial costs are covered. The formula for calculation of the financial break-even point is as follows:

Financial break-even point = I + PSD/1-T

Where:

I – interest charges

PSD – preferred stock dividends

T – tax rate

***

This capital structure approach does NOT allow us to determine the point where weighted average cost of capital is at a minimum and where stock price is at a maximum (where wealth of the owners of the firm is maximized). The approach focuses on maximizing earnings rather than on maximizing wealth. Therefore, although it is helpful to use when analyzing alternative capital structures, the major shortcoming of this approach should be taken into account.

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Optimal capital structure

Theoretically, enterprises should try to maintain a certain optimal capital structure, a perfect mix of financing (debt and equity), which results in the lowest possible weighted average cost of capital. At this combination of debt and equity, the stock price is at the maximum. Therefore, attainment of the optimal structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. The optimal structure is also referred to as the target capital structure. However, it is important to note the optimal structure exists only in theory.

Theory does not yet offer a methodology that would allow firms’ financial managers to find the optimal capital structure. However, financial managers can determine the approximate optimal structure range, which is close to what they believe the optimal structure for the firm is.

As per above, an optimal structure maximizes the value of the firm. To find the value of the firm, we can use the following formula:

V=EBIT*(1-T)/ra

Which simplifies into:

V=NOPAT/ra

Where:

V = is the value of the firm

EBIT = is earnings before interest and taxes (see the income statement for how it is calculated)

NOPAT = is the net operating profit after taxes (calculated by formula EBIT*(1-T)/ra)

ra = is the weighted average cost of capital (WACC)

If we assume that NOPAT is consistent, then the value of the firm is affected by WACC (ra, weighted average cost of capital). WACC is affected by both, the cost of debt and equity.

The cost of equity


The cost of equity is higher than the cost of debt and increases as financial leverage increases. This is because equity suppliers will demand higher return for increasing financial risk due to increasing financial leverage.

The cost of debt


The cost of debt initially is relatively low. The major reason for this is due to the fact that interest on debt is tax deductible. This tax deductibility of interest paid on debt is also commonly called the tax shield. However, as debt increases, at certain debt ratio lenders will begin to require higher and higher interest payments from the borrower. This is undertaken in order to compensate for increasing risk due to increasing financial leverage.

There are two other costs of debt that the firm needs to consider:

(1) Debt increases the probability of bankruptcy. This is because lenders can force the firm into bankruptcy if the firm cannot meet its financial obligations to the lender.

(2) Another aspect to consider is the agency cost. This refers to the fact that lenders usually protect themselves from increases in risk of the borrower by imposing different loan provisions, which place constraints on actions and choices of the firm. Such provisions commonly include, but are not limited to, minimum levels of liquidity to be maintained, limits on compensation of the executives and limitations on asset acquisitions.

***

As debt increases from a zero point onwards, WACC initially decreases to the theoretical optimal capital structure point. Thereafter, the increasing equity cost and increasing cost of debt causes WACC to start increasing again. Therefore the theoretical optimal capital structure is obtained at the point where the WACC is the lowest.

In other words, the theoretical optimal capital structure occurs at the point where the benefits from using debts are in equilibrium (in balance) with the costs of using debt. The optimal capital structure can also be seen as the balance between risk and return where the firm’s stock price is maximized.

 

Capital structure decisions analysis with debt ratios

When analyzing capital structure decisions, external stakeholders can obtain an approximate idea of the capital structure of the particular firm by using information in the firm’s financial statements to calculate various debt ratios.

When analyzing capital structure decisions of firms as outsiders, we need to consider two types of debt measures:

The first type of debt ratio measures the degree of indebtedness. This refers to how much debt the firm has relative to other balance sheet’s amounts. The debt ratio will measure the degree of indebtedness.

The second type of debt ratio measures the ability to service debts. This type of debt ratios measures the ability of the business to meet its obligations associated with debt, as they come due. Times Interest Earned Ratio and Fixed Payment Coverage Ratio will be considered to measure the ability to service debts.

Both techniques are very simple to use and effective at analysing capital structure decisions.

Measuring the degree of indebtedness


THE DEBT RATIO

A direct measure of debt is a debt ratio. Debt ratios provide direct information on the financial leverage of an enterprise. Debt ratios measure how many of the firm’s assets are financed by debt. The higher the debt ratio, the higher the degree of financial leverage (amount of debt) and the higher the risk. The formula for the debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

Example:

For example, assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Measuring the ability to service debts


TIME INTEREST EARNED RATIO (INTEREST COVERAGE RATIO)

The Times Interest Earned Ratio (TIER or Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due).

When analyzing capital structure decisions, we can use the Times Interest Earned Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Times Interest Earned Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Times Interest Earned Ratio is as follows:

Times Interest Earned Ratio =EBIT/interest charges

EBIT refers to the earnings before interest and taxes, which is also called operating profit (refer to the Income Statement format to see how it is calculated).

EXAMPLE:

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000.

The TIER of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

When using the Times Interest Earned Ratio, it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio. It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest. The calculation above excludes the principal amount borrowed.

Generally, the higher the Times Interest Earned Ratio the lower the risk an enterprise will not be able to meet its contractual interest obligations on time. Therefore, generally, a higher Times Interest Earned Ratio is the better.

However, cognizance needs to be taken of the fact that the higher the Times Interest Earned Ratio, the lower the risk and lower the return. Therefore, at some point, the Times Interest Earned Ratio may be too high. This will occur if the business is unnecessarily careful with taking up debt as a source of financing, which results in very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

FIXED PAYMENT COVERAGE RATIO

Fixed Payment Coverage Ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. When analyzing capital structure decisions, we can use the Fixed Payment Coverage Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Fixed Payment Coverage Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Fixed Payment Coverage Ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT – earnings before interest and tax (operating profit)

LP – lease payments

I – interest charges

PP – principal payments

PSD – preferred stock dividends

T – tax rate

EXAMPLE:

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The Fixed Payment Coverage Ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The Fixed Payment Coverage Ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, Fixed Payment Coverage Ratio should be compared to industry average before any conclusions are drawn. Generally, the higher the Fixed Payment Coverage Ratio the lower the risk that enterprise will not be able to meet its fixed-payment obligations on time. Therefore, a higher Fixed Payment Coverage Ratio is the better.

However, as with Times Interest Earned ratio, cognizance needs to be taken of the fact that the higher the Fixed Payment coverage ratio the lower the risk and lower the return. Therefore, at some point, the Fixed Payment Coverage Ratio may be too high. This will occur if the business is unnecessarily careful with taking up more debt which results in a very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

***

When analyzing capital structure decisions with the help of debt ratios, one should compare debt ratios of individual firms to industry averages. There is a large variability of debt ratios’ industry averages between industries. This is because different industries have different operations requirements. There is no one perfect ratio. Appropriate ratios to use should determined by the company in question, taking into account company’s ‘s strategy, operating environment, competitive environment and finances.

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How to calculate EPS (Earnings per Share)?

Calculating earnings per share (EPS) allows us to understand how much dollars were earned on each outstanding share of common stock.

In summary, in order to find earnings per share (EPS), we need to take earnings available for common stockholders (the bottom line of the income statement ) and divide it by number of shares of common stock outstanding.

Earnings per Share (EPS) = Earnings Available for Common Stockholders/ Number of Shares of Common Stock Outstanding

Therefore, in order to determine EPS (earnings per share), we need to know earnings available for common stockholders. Earnings available for common stockholders are calculated as follows:

Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

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Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (TIER), also known as the Interest Coverage Ratio, measures the ability of the enterprise to meet its financial obligations (interest payments on debt due). The formula for TIER is as follows:

Times Interest Earned Ratio = EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to the format of an income statement to see how it is calculated).

Example


Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The Times Interest Earned Ratio (TIER) of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio (TIER) could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

Things to note about this ratio


When using the Times Interest Earned Ratio (TIER), it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio (TIER). It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest.

One should compare debt ratios of individual firms to industry averages, to obtain a better understanding. There is a large variability of debt ratios industry averages between industries. This is because different industries have different operations requirements.

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Fixed Payment Coverage Ratio

The fixed payment coverage ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. In other words, the fixed payment coverage ratio measures the ability to service debts.

As outsiders, when analyzing the capital structure decisions of firms, we can use the fixed payment coverage ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk.

The formula for the fixed payment coverage ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT = earnings before interest and tax (operating profit)

LP = lease payments

I = interest charges

PP = principal payments

PSD = preferred stock dividends

T = tax rate

Test yourself


Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The fixed payment coverage ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The fixed payment coverage ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, the ratio should be compared to the industry average before any conclusions are drawn.

Note the following


Generally, the higher the ratio the lower the risk that  enterprise will not be able to meet its fixed-payment obligations on time. Therefore, generally, a higher ratio is better. However, as with times interest earned ratio, cognizance needs to be taken of the fact that the higher the ratio the lower the risk and lower the return.

Therefore, at some point, the fixed payment coverage ratio may be too high. This will occur if a business is unnecessarily careful with taking up more debt. This will result in very low risk, but also in lower return. This, of course, is not aligned with the overall goal of the enterprise, which is the maximization of the wealth of its shareholders.

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Earnings Available for Common Stockholders

In summary, to calculate earnings available for common stockholders, we need to subtract cost of goods sold, operating expenses, and interest, tax and preferred stock dividends from sales revenue.

To calculate these earnings available, we need to understand the format of the income statement.

Income Statement Format


Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate earnings available for common stockholders, all we need to do is to subtract cost of goods sold, operating expenses, interest, tax and preferred stock dividends from the sale revenue.

Knowing the the earnings available for common stockholders is very important. Among other uses, it allows us to do the following:

1 – It allows you to calculate EPS:

Calculating EPS allows us to understand how much dollars were earned on each outstanding share of common stock.

2 – It also allows you to calculate the net profit margin ratio:

Net Profit Margin ratio = Earnings Available for Common Stockholders / Sales.

Net profit margin ratio measures how much of each sales dollar remains after all costs are deducted. In other words it measures how successful the firm is in terms of its earnings on sales.

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