Financial Leverage

What is Financial Leverage?

If operating leverage results from the existence of operating expenses in the enterprise’s income stream, then financial leverage results from the presence of fixed financial charges in the firm’s income stream.

In fact, financial leverage relates to financing activities, i.e., the cost of raising funds from different sources carrying fixed charges or not involving fixed charges. For example, if funds are raised through long-term debts such as bonds, debentures, these instruments carry fixed charges in the form of interest, which should be paid irrespective of the operating profits.

In contrast, if funds are raised through equity shares, then the dividend to be paid is not a fixed charge and further, it is paid out of operating profits. If the funds are raised by preference shares, though they do not carry fixed charge of interest, they carry the fixed rate of dividend. Therefore, dividend payable to preference shareholders is considered as fixed charge while calculating financial leverage.

It should be noted that equity shareholders are entitled to the remainder of the operating profits of the firm after meeting all the prior obligations. Thus financial leverage measures the relationship between the operating profit (EBIT) and the earning per share (EPS) to equity shareholders. It is calculated as a percentage change in the EPS divided by a percentage change in EBIT. When calculating financial leverage, we should note that the EBIT is no doubt a dependent variable but it is determined by the level of EPS.

Formula to Calculate Financial Leverage

Formula-to-calculate-Financial-Leverage

For calculating both operating leverage and financial leverage, EBIT is termed as linking point in the leverage  study. When calculating the operating leverage, EBIT is a dependant variable and is determined by the level of sales. When calculating financial leverage, EBIT is no doubt a dependant variable but is determined by the level of EPS. In fact, EPS is calculated by using the below formula:

Formula-to-Calculate-EPS

How to Calculate Degree of Financial Leverage

To calculate the degree of financial leverage, let’s take an example.

XYZ Company has an EBIT of $1,000,000. The interest liability is $150,000. It has issued 10% preference shares of $500,000 and 50,000 equity shares of $100 each. The average tax applicable to the company is 30% and corporate dividend tax is 20%. Calculate the degree of financial leverage.

Solution

Calculating-Degree-of-financial-leverage

Number of equity shares 50,000

EPS = Earning available to equity holders / Number of shares = 535,000 / 50,000

EPS = 10.7

Financial Leverage = EBIT / EBT -D ÷ (1 – t)

= 1,000,000 / 850,000 – 60,000 ÷ (1 – 0.30)

= 1,000,000 / 850,000 – (60,000 ÷ 0.7)

= 1.000.000 / 850,000 – 85,714

Therefore, Degree of FL = 1,000,000 / 764,286 = 1.308

Example

Let us examine how EPS will be varying at different levels of EBIT taking into account:

  1. actual level
  2. % increase in EBIT, and
  3. % decrease in EBIT.

The EBIT or HT Ltd for the current year is assumed to be $1,000,000. The company has 5% bonds amounting to $400,000. What would be the EPS per share? Suppose the EBIT is:

  1. $1,200,000
  2. $800,000

how would be the EPS be affected? It can be assumed that the company comes under the tax bracket of 40%. The number of outstanding equity shares is 100,000. Calculate the financial leverage and interpret the result.

Solution

Example-to-calculate-FL

Interpretation of Results

EPS = Earnings available to equity holders / Number of shares

= 548,000 / 100,000 = 5.48

= 668,000 / 100,000 = 6.68

= 428,000 / 100,000 = 4.28

  1. When EBIT is raised from $1,000,000 to 1,200,000 with an increase of 20%, it results in 21.90% increase in EPS, i.e., increase from 5.48 to 6.68 (6.68 – 5.48 = 1.20 ÷ 5.48 x 100).
  2. When EBIT is decreased from $1,000,000 to $800,000 with a decrease of 20% , it results in 21.90% decrease in EPS, ie., decrease from 5.48 to 4.28 (5.48 -4.28 = 1.20 ÷ 5.48 x100).

Thus, the prospects of financial leverage help the finance manager to make an appropriate decision by comparing the cost of debt financing with the average return on investment.

  1. If ROI is more than the cost of debt financing, then it is called favorable financial leverage or trading on equity or positive financial leverage. This situation encourages the finance manager to go in for more and more debt financing to enhance the benefits to shareholders.
  2. If ROI is less than the cost of debt financing, it is not worth while to go for debt financing, because losses get increased and the benefits to shareholders get decreased. this situation is called unfavorable financial leverage or negative financial leverage.
  3. If ROI is equal to the cost of debt financing, it is not advisable to borrow funds as the company may not be able to generate surplus earnings by debt financing.

To conclude, financial leverage emerges as a result of fixed financial cost (interest on debentures and bonds + preference dividend). If the financial leverage is positive, the finance manager can go for increasing the debt to enhance benefits to shareholders. Where the earning is either equal to fixed financial charge or unfavorable, debt financing should not be encouraged.

Operating and Financial Leverage Viewed Together

Opearing leverage helps in determining the reasonable level of fixed costs, whereas financial leverage helps in determining the extent of debt financing. Both financial and operating leverage emerge from the base of fixed costs, i.e., operating leverage appears where there is fixed financial charge (interest on debt and preference dividend). The variability of sales level (operating leverage) or due to fixed financing cost affecting the level of EPS (financial leverage).

It is observed that debt financing is relatively cheaper compared to financing through equity. this encourages finance managers to go in for more of debt financing. Simultaneously, one should be conscious as to the risk involved in increasing debt financing, i.e., the risk may lead to bankruptcy. Therefore, it is suggested to have a trade-off between debt and equity so that the shareholders interest is not affected adversely.

Thus, both operating and financial leverage are related to each other. In the sense, both of them when taken together, multiply and magnify the effect of change in sales level on the EPS. However, operating leverage has direct impact on sales level and is called first-order leverage whereas FL ha an indirect effect on sales and is called second-order leverage. If, the operating leverage explains business risk, then FL explains financial risk.

In conclusion, the higher the operating leverage, the more the company’s income is affected by fluctuation in sales volume. If the sales volume is significant, it is beneficial to invest in securities bearing the fixed cost. In the case of financial leverage, the higher the amount of debt, the higher ios the FL. High leverage may be beneficial in boom periods as there might be sufficient cash flow. During the recessionary period, it may cause serious cash flow problems, as there might not be enough sales revenue to cover the interest payments. However, the finance manager should carefully view the situation and make a decision to enhance the benefits to shareholders. To cover the total risk and to be precise in one’s decision, the financial manager may rely on combined leverage.

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