What do we understand by leverage? In simple terms leverage means the use of debt to improve the performance of a company. How to measure financial performance of a company? Obviously one of the major ways of doing it is by evaluating profitability and that is impacted by your leverage. What is the effect of financial leverage on company performance? It would depend on the extent of the leverage and the cost of leverage as we shall see later. That means there are three distinct factors to consider here viz. the extent of the leverage, the composition of the leverage and the cost of the leverage. Let us look at the relationship between financial leverage and financial performance by looking at these perspectives of leverage..
Looking at the extent of leverage..
The most common measure of the extent leverage is the debt/equity ratio or the Asset/Equity ratio. It shows the extent of leverage in the balance sheet of the company. Let us consider the balance sheet of the Company X as under:
Balance Sheet of Company X for 2016-17
Liabilities SideTotal AmountAssets SideTotal AmountEquity Capital10,00,000Land and Building10,00,000General Reserves15,00,000Plant & Machinery35,00,000Share Premium A/C5,00,000Other Long term assets15,00,000Total Equity30,00,000Total Fixed Assets60,00,000Long Term Loans20,00,000Cash on Hand6,00,000Bonds issued10,00,000Debtors8,00,000Total Long Term Debt30,00,000Inventories6,00,000Short term loans8,00,000Total Current Assets20,00,000Current Liabilities12,00,000
Total Short Term Debt20,00,000
Total Liabilities80,00,000Total Assets80,00,000
There are two ways to look at the leverage here. The first way is to look at the pure debt equity ratio..
Leverage 1 = Long Term Debt / Equity
Leverage 1 = 30,00,000 / 30,00,000 = 1
A debt/equity ratio of 1 is considered to be very attractive for most manufacturing companies, although service companies have more conservative debt equity ratios. Normally, when long term debt is considered, that portion of long debt that is maturing in the next 1 year is excluded from this calculation. But the leverage above is purely a balance sheet measurement. It does not really look at the composition of the debt and the composition of the assets in the above case.
Alternatively one can also look at leverage as the Total Assets / Equity which would be 8/3 in this case.
Looking at the quality of leverage..
The second approach to leverage is to look at the quality of leverage. There are various approaches to leverage but let us look at two of them. Firstly, tenure of loans makes a difference to the quality. For example, too much of repayments coming up in the next 2-3 years are more risky than repayments being bunched after 7-8 years. It gives more leeway to the company to grow in the meanwhile. Second and very important is the foreign currency loan component. Normally companies raise money through Foreign Currency Convertible Borrowings (FCCB) and External Commercial Borrowing (ECB). In both these cases, the dollar currency risk is on the issuer which can become a challenge if the INR depreciates versus the dollar. Consider the illustration..
Time of ECB IssueDetailsTime of RedemptionDetailsDate of issueJan 01, 2015Redeem Units100,000Term of Issue5 yearsRedemption price$1000Nature of Bond IssueDeep Discount BondRedemption value$100,000,000 ($100 m)Number of Bonds100,000 unitsINR / Dollar Rate75/$Issue Price$800Rupee RedemptionRs.750 croreRedemption Price$1000Extra rupee funds paidRs.100 croreImplied Yield4.565%Rupee Yield paid7.600%INR / Dollar rate65/$Excess Yield due to INR depreciation3.035%Amount Raised$80,000,000 ($80 m)
Rupee Amount RaisedRs.520 crore
Rupee Redemption anticipatedRs.650 crore
As can be seen in the above case, because the INR depreciated versus the dollar over 5 years, the company had to repay an additional Rs.100 crore in rupee terms and that pushed the rupee yield for the company by 3.035%. Normally companies tend to hedge their currency risks but any un-hedged currency position creates a major risk.
Understanding cost of leverage..
Another way of looking at leverage is by looking at the cost of leverage. In technical parlance we called it the coverage ratios or the interest coverage ratio to be precise. Take the illustration below of 3 different companies with the same level of leverage..
ParticularsCompany ACompany BCompany CTotal RevenuesRs.25 croreRs.40 croreRs.60 croreEBIT (60%)Rs.15 croreRs.24 croreRs.36 croreInterest CostRs.12 croreRs.12 croreRs.12 croreInterest Coverage1.25 times2.00 times3.00 times
Obviously, Company C is the best placed in terms of interest coverage ratio followed by Company B and then by Company A. There are 2 factors at play here. Firstly, Company C is able to generate higher sales for a given level of leverage and therefore with a constant EBIT margin it enjoys a higher EBIT. Company has a problem of higher relative debt costs which makes it more vulnerable in terms of coverage.
Leverage needs to be looked at from 3 dimensions. Apart from the quantum of debt and the composition of debt, the cost of debt in the form of coverage ratios also makes a big difference to its vulnerability.