Financial Leverage


Financial leverage-what?

Financial leverage comes from fixed financial costs, just like operating leverage comes from operating expenses.

Financial leverage refers to financing activities (including the cost of raising funds from fixed- or non-fixed-charge sources).

Interest is charged on long-term debts like bonds and debentures. This must be paid regardless of operating profitability.

Equity shares raise funds without a fixed dividend. It also comes from operating profits.

Preference shares raise funds without a fixed interest rate but carry a fixed dividend rate.

Preference shareholder dividends are considered fixed charges when evaluating financial leverage.

After completing their obligations, equity stockholders get the remaining operating profits.

Financial leverage compares operating profit (EBIT) to equity shareholder EPS. EPS percentage change divided by EBIT percentage change yields it.

EBIT is a dependent variable of EPS when assessing financial leverage.

Formula for Financial Leverage

In leverage analysis, EBIT links operating and financial leverage. EBIT is a sales-dependent measure in operating leverage calculations.

Calculating Financial Leverage

Consider an example to measure financial leverage.

EBIT for XYZ Company is $1,000,000.

We owe $150,000 in interest. The company issued 50,000 $100 equity shares and 10% preference shares of $500,000. Average company tax is 30% and corporate dividend tax is 20%.

Financial leverage must be calculated.

Solution: 50,000 equity shares.

Equityholder earnings / 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

Thus, financial leverage = 1,000,000 / 764,286 = 1.308.

Example

Take into account the following when examining EPS at different EBIT levels:

Actual level

Increased EBIT percentage

EBIT decline percentage

Assume HT Limited’s current year EBIT is $1,000,000. The corporation holds $400,000 in 5% bonds. What’s EPS? Suppose EBIT is:

$1,200,000

$800,000

This affects EPS how? You can suppose the corporation pays 40% taxes. There are 100,000 equity shares outstanding.

Financial leverage must be calculated and interpreted.

Interpretation of Solution

Divide equity holders’ earnings by the number of shares.

= 548,000 / 100,000 = 5.48

= 668,000 / 100,000 = 6.68

= 428,000 / 100,000 = 4.28

A 20% rise in EBIT from $1,000,000 to $1,200,000 leads to a 21.90% increase in EPS, from 5.48 to 6.68 (6.68 – 5.48 = 1.20 ÷ 5.48 x 100).

A 20% fall in EBIT from $1,000,000 to $800,000 leads to a 21.90% decrease in EPS, from 5.48 to 4.28 (5.48 -4.28 = 1.20 ÷ 5.48 x100).

Calculations like those above help the finance manager make judgments by comparing debt financing costs to average ROI.

Trading on equity or positive financial leverage occurs when ROI exceeds debt financing costs.

This pushes the finance manager to seek greater debt funding to boost shareholder value.

If ROI is less than debt financing cost, losses increase and shareholder benefits decline, making debt financing unwise.

Financial leverage is negative in this case.

If ROI equals debt financing cost, the corporation may not produce surplus earnings by borrowing capital.

Fixed financial costs (debenture and bond interest + preference dividend) create financial leverage.

If financial leverage is positive, the finance manager can increase debt to benefit shareholders.

Debt financing should be avoided when earnings are equivalent to fixed financial charges or negative.

Combined Operating and Financial Leverage

Operating leverage determines fixed costs, while financial leverage determines debt financing.

Fixed costs generate financial and operating leverage. Thus, operating leverage occurs when loan interest and preference dividends are fixed.

Sales fluctuation (operating leverage) or constant finance costs effect EPS.

Debt financing is cheaper than equity. This encourages finance managers to borrow more.

Additionally, increased debt financing has dangers, including bankruptcy.

Therefore, a debt-equity trade-off is recommended to protect shareholders’ interests.

This debate shows that operating and financial leverage (FL) are related.

When combined, they enhance the sales level influence on EPS.

Operating leverage affects sales directly, while FL indirectly affects sales.

FL describes financial risk if operating leverage explains business risk.

The stronger the operating leverage, the more sales volume changes affect the company’s income.

Investment in fixed-cost securities is profitable if sales volume is high.

Higher debt equals higher FL. Boom eras may benefit from high leverage since cash flow is sufficient.

It may pose cash flow issues during recessions.

Because sales proceeds may not cover interest payments.

However, the finance manager should thoroughly examine the situation and make a decision that favors shareholders.

The financial manager may use combined leverage to cover all risk and make precise decisions.


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