LEVERAGES
The practice of borrowing money
to increase potential returns
What is Leverage?
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In finance, leverage is a strategy that
companies use to increase assets, cash flows,
and returns, though it can also magnify losses.
There are two main types of leverage: financial
and operating. To increase financial leverage, a
firm may borrow capital through issuing fixed-
income securities or by borrowing money
directly from a lender.
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Operating leverage can also be used to magnify
cash flows and returns, and can be attained
through increasing revenues or profit margins.
Both methods are accompanied by risk, such
as insolvency, but can be very beneficial to a
business.
Financial Leverage
When a company uses debt financing, its
financial leverage increases. More capital is
available to boost returns, at the cost of interest
payments, which affect net earnings.
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Example 1
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Bob and Jim are both looking to purchase the
same house that costs $500,000. Bob plans to
make a 10% down payment and take a
$450,000 mortgage for the rest of the payment
(mortgage cost is 5% annually). Jim wants to
purchase the house for $500,000 cash today.
Who will realize a higher return on investment if
they sell the house for $550,000 a year from
today?
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Although Jim makes a higher profit, Bob sees a
much higher return on investment because he
made $27,500 profit with an investment of only
$50,000 (while Jim made $50,000 profit with a
$500,000 investment).
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Example 2
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Using the same example above, Bob and Jim
realize they can only sell the house for
$400,000 after a year. Who will see a greater
loss on their investment?
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Now that the value of the house decreased,
Bob will see a much higher percentage loss on
his investment (-245%), and a higher absolute
dollar amount loss because of the cost of
financing. In this instance, leverage has
resulted in an increased loss.
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Financial Leverage Ratio
The financial leverage ratio is an indicator of
how much debt a company is using to finance
its assets. A high ratio means the firm is highly
levered (using a large amount of debt to finance
its assets). A low ratio indicates the opposite.
XYX Inc.
Total Assets = 1,100
Equity = 800
Financial Leverage Ratio = Total
Assets / Equity = 1,100 / 800
= 1.375x
XYW Inc.
Total Assets = 1,050
Equity = 650
Financial Leverage Ratio = Total
Assets / Equity = 1,050 / 650
= 1.615x
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Company XYW Inc. reports a higher financial
leverage ratio. This indicates that the company
is financing a higher portion of its assets by
using debt.
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Operating Leverage
Fixed operating expenses, combined with
higher revenues or profit, give a company
operating leverage, which magnifies the upside
or downside of its operating profit.
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Example
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The income statement of Companies XYZ and
ABC are the same. Company XYZ’s operating
expenses are variable, at 20% of revenue.
Company ABC’s operating expenses are fixed
at $20.
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Which company will see a higher net income if
revenue increases by $50?
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If revenue increases by $50, Company ABC will
realize a higher net income because of its
operating leverage (its operating expenses are
$20 while Company XYZ’s are at $30).
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Which company will realize a lower net income
if revenue decreases by $50?
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When revenue decreases by $50, Company
ABC loses more due to its operating leverage,
which magnifies its losses (Company XYZ’s
operating expenses were variable and adjusted
to the lower revenue, while Company ABC’s
operating expenses stayed fixed).
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Operating Leverage Formula
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The operating leverage formula measures the
proportion of fixed costs per unit of variable or
total cost. When comparing different
companies, the same formula should be used.
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Financial Leverage:
Financial Leverage is a tool with which a
financial manager can maximise the returns to
the equity shareholders. The capital of a
company consists of equity, preference,
debentures, public deposits and other long-term
source of funds. He has to carefully select the
securities to mobilise the funds. The proper
blend of debt to equity should be maintained.
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The ratio through which he balances the mix of
debt applied on the capital mix offers benefits to
the equity shareholders is known as Trading on
Equity. As the debt is associated with the cost
of interest that can be directly charged to profit
and loss account or charged against the profit
can reduce the burden of income tax. The
benefit so gained will be passed on to the
equity shareholders. In such circumstances the
EPS will be more.
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If the company prefers to raise the amount of debt instead of equity,
it will lose the opportunity of charging the interest directly against
the profit, as a result of this, it had to pay more tax to the
government and in turn earnings available to equity shareholders
would reduce. Hence, in other words, financial leverage refers to the
use of fixed charge securities in the capitalisation of company to
produce more gains for the equity shareholders.
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Thus, the financial leverage signifies the
relationship between the earning power on
equity capital and rate interest on borrowed
capital. If the earnings of the company has more
amount of fixed cost of interest (which would
arise due to more debt capital), the overall
returns of a company get reduced and financial
risk increases. This may be an unfavourable
situation for business concern and practically
not advocated. The more accepted ratio
between debt to equity is 2:1. This ratio favours
leverage effect on equity shares and would get
higher percentage of earnings.
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The two quantifiable tools, viz., operating and
financial leverage are adopted to know the
earnings per share and also which shows the
market value of the share. (Price earning ratio by
EBIT) Thus, financial leverage is a better tool
compared to operating leverage. Change in EPS
due to changes in EBIT results in variation in
market price.
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Therefore, financial and operating leverages act as
a handy tool to the analyst or to the financial
manager to take the decision with regard to
capitalisation. He can identify the exact relationship
between the EPS and EBIT and plan accordingly.
High leverage indicates high financial risks which
would signal the finance manager to select the
securities carefully.
Operating Leverage:
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There are two major classification of costs in
the organisation. They are- (a) Fixed cost, (b)
Variable cost.
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The operating leverage has a bearing on fixed
costs. There is a tendency of the profits to
change, if the firm employs more of fixed costs
in its production process, greater will be the
operating cost irrespective of the size of the
production. The operating leverage will be at a
low degree when fixed costs are less in the
production process.
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Operating leverage shows the ability of a firm to
use fixed operating cost to increase the effect of
change in sales on its operating profits. It
shows the relationship between the changes in
sales and the charges in fixed operating
income. Thus, the operating leverage has
impact mainly on fixed cost, variable cost and
contribution.
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It indicates the effect of a change in sales
revenue on the operating profit (EBIT). Higher
the operating leverage indicates higher the
amount of fixed cost and reduces the operating
profit and increases the business risks.
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In the previous illustration, we have learnt that
25,000 units of production will not yield any
operating profit or the company has reached
the break-even. Any units which are produced
beyond 25,000 units yields operating profits.
Therefore, any increases in sales, fixed costs
remaining same, increases operating profit. The
increase in percentage operating income due to
percentage, of increase in sales is called as
“Degree of operating leverage”.
Combined Leverage:
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This leverage shows the relationship between a
change in sales and the corresponding variation
in taxable income. If the management feels that
a certain percentage change in sales would
result in percentage change to taxable income
they would like to know the level or degree of
change and hence they adopt this leverage.
Thus, degree of leverage is adopted to forecast
the future study of sales levels and resultant
increase/decrease in taxable income. This
degree establishes the relationship between
contribution and taxable income.
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Example:
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A company, has a sales of Rs.2 lakh. The
variable costs are 40 per cent of the sales and
fixed expenses are Rs.60,000. The interest on
borrowed capital is assumed to be Rs.20, 000.
Compute the combined leverage and show the
impact on taxable income when sales increases
by 10 per cent.