Degree of financial leverage

Degree of financial leverage can be defined as caused by change in EBIT (earning before interest and tax), the procentage change in taxable profit. Financial leverage is company's capability to increase the earnings per share as the effect of changes in EBIT, by using fixed financial charges. Company expects increasing of the shareholders' return by right usage of funds that it gained at the fixed cost. There are two types of financial leverage results (C.Paramasivan 2009, p. 86):

• Profitable (positive) financial leverage - this is desirable type of leverage. It occurs when the constant cost of funds which company purchased it's assets are lower than earnings of their usage. Positive financial leverage can be called favourible.
• Unprofitable (negative) financial leverage - this type of leverage is opposed to the first one. The funds costs are larger than earnings of the company. Negative financial leverage can be called unfavourable.

Calculation of the financial leverage is concluded in following formula:

$FL={\frac {OP}{PBT}}$

Where:

• FL is financial leverage
• OP is EBIT (operating profit)
• PBT is profit before tax

Calculation of the degree of financial leverage is concluded in following formula:

$DFL={\frac {PCTI}{CEBIT}}$

Where:

• DFL is degree of financial leverage
• PCTI is procentage change in taxable income
• CEBIT is change in earning before interest and tax.

Financial leverage usage

There are few examples of financial leverage usage (C.Paramasivan 2009, p. 88):

• Financial leverage is important device in analysing proportion between fixed costs and total capital.
• We can use financial leverage in choosing structure of the capital that provides positive financial decisions.

Market can collect information about economic results by analysing changes in financial leverage. This information is potentially more than the one we can receive from earnings alone. Increasing financial leverage is signal that situation on market have deteriorated. And the other way, declining financial leverage is a sign of improved performance on market. Change in financial leverage is negatively connected with risk-adjusted stock return as long as market analyse its performance in stock prices. That means that changes in financial leverage are relevant value (V. Dimitrov 2006, p. 6).

Increasing financial leverage in merging

Sometimes merging companies have increased their financial leverage. There are two possible reasons of this situation. First one is connected with merge debt capacity increase. Second one is debt that companies didn't use before merge (A. Ghosh 2000 p. 1-5).

1. Debt capacity theory - debt capacity is influenced by the company size. Financial leverage is relatively higher in larger firms. It is caused by fact that greater companies' default risk is lower. Debt capacity can be measured by financial leverage of ingenuity and size matched firms. Using market value as a size rate, those firms are matched on the joint size of the target company (the one that will be created by merger) and merging firms. Market value rates are taken from one year before merger. Financial leverage of the matched companies over years before merger is higher than merging firms if debt capacity is related with size of firms positively.
2. Unused debt capacity theory - one or both of the merging companies can have unused debt capacity that come from years before merging. Financial leverage can be increased by the utilization of unused debt capacity and it is more possible than debt capacity increase. To analyse if increase of financial leverage is caused by unused debt capacity, leverages of target and acquiring companies are being compared separately with close size and ingenuity matched ones. Then debt capacity is separately estimate for acquiring and target companies for years before merger. After that, financial leverage in actual value is compare to benchmark leverage. If actual is less than benchmark, we can assume that leverage following mergers is increasing at least partly as result of unused debt capacity from past.

Influence on investment

Financial leverage have got influence into investment and according to that on the business risk. It is caused by that it affects the effective degree of irreversible investement. Investements can be financed with leverage. When it happens, the effective value of capital is reduced by connected with debt financing tax savings for the time of investement. At the time without investement, company is forced to pay back debt (according to debt agreement). Therefore, company gives up tax savings connected with peculiar investement debt financing. The resale price is lower than purchase and both of these prices should be adapted to same value of tax savings. Because of that their ratio rises as a debt financing result (A. K. Ozdagli 2012, p. 5).

Examples of Degree of financial leverage

• Operating Leverage - Operating leverage is the degree of fixed operating costs (costs that are not directly related to the number of units produced) that a business has relative to its variable operating costs (costs that are related directly to the number of units produced). Generally, a business that has high fixed operating costs and low variable costs will have a high operating leverage. For example, a business that produces widgets and has high fixed costs, such as the cost of a factory, but low variable costs, such as the cost of raw materials for the widgets, will have high operating leverage.
• Financial Leverage - Financial leverage is the use of borrowed capital to increase the potential return of an investment. It is calculated by taking the ratio of total debt to total assets. For example, a company that has $10 million in total assets and $5 million in total debt has a financial leverage ratio of 0.5, which means that the company is using 50% leverage. This leverage can be beneficial if the return on the investment is higher than the cost of borrowing, but it can also be risky if the return is not sufficient to cover the cost of the debt.

Advantages of Degree of financial leverage

• The degree of financial leverage can provide significant advantages to a company. Firstly, it allows a company to increase its earnings per share of stock by utilizing funds at a fixed cost. This can result in increased returns for shareholders. Secondly, it allows a company to increase its debt capacity, which in turn can increase its borrowing power and enable it to finance larger projects that may generate higher returns. Thirdly, it can create a tax shield, as some of the interest payments on the debt are tax deductible. Finally, it can help to increase the market value of a company’s shares, as investors may perceive the company as having greater financial strength.

Limitations of Degree of financial leverage

The limitations of Degree of financial leverage include:

• Risk of insolvency - If the company’s earnings are not sufficient to cover the fixed financial charges, the company may become insolvent.
• Increased volatility of earnings - As the fixed financial charges stay the same, any changes in the company’s operating income will have a greater effect on the company’s taxable profit.
• Dependence on debt - A company with a high degree of financial leverage is dependent on debt and may be at risk of default if it cannot service its debt obligations.
• Interest rate risk - Companies with high levels of financial leverage are more exposed to interest rate fluctuations, as they are more dependent on borrowing at a fixed rate.
• Impact on company valuation - The degree of financial leverage can have an impact on company valuation, as it affects the company’s earnings per share.
• Pressure on cash flows - High levels of financial leverage can put pressure on a company’s cash flows, as it has to make payments on its debt obligations.

Other approaches related to Degree of financial leverage

• Debt Ratio: This is a measure of a company’s financial leverage calculated by dividing its total liabilities by its total assets.
• Times Interest Earned Ratio: This is a measure of a company’s ability to pay its interest expenses on outstanding debt. It is calculated by dividing a company's earnings before interest and taxes by its interest expenses.
• Interest Coverage Ratio: This is a measure of a company's ability to pay its interest obligations. It is calculated by dividing a company's earnings before interest and taxes by its interest expenses.
• Debt-to-Equity Ratio: This is a measure of a company's financial leverage calculated by dividing its total liabilities by its total equity.

In summary, other approaches related to degree of financial leverage include debt ratio, times interest earned ratio, interest coverage ratio, and debt-to-equity ratio. These measures provide insight into a company’s ability to pay its debt obligations and its overall financial leverage.

Degree of financial leverage — recommended articles

Debt management ratio — Market value added — Capital gearing — Ebitda ratio — Plowback Ratio — Asset equity ratio — Capitalization ratios — Return on common equity — Free cash flow yield

References

• Dimitrov, V., & Jain, P. C. (2006). The value relevance of changes in financial leverage. Whitecomb Center for Research in Financial Services, 2006.
• Ghosh, A., & Jain, P. C. (2000). Financial leverage changes associated with corporate mergers. Journal of Corporate Finance, 6(4), 377-402.
• Kim, E. H., Lewellen, W. G., & McConnell, J. J. (1979). Financial leveregae clienteles: Theory and evidence. Journal of Financial Economics, 7(1), 83-109.
• Ozdagli, A. K. (2012). Financial leverage, corporate investement, and stock returns. The Review of Financial Studies, 25(4), 1033-1069.
• Paramasivan, C., & Subramanian, T. (2009). Financial management. New Age International (P) Limited 2009.

Author: Maciej Soczówka