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What is financial leverage and how can it be applied practically?

05 Jan 2023

Financial leverage is the second aspect of leverage other than operating leverage. When we refer to financial leverage we are referring to the inclusion of debt in the capital structure of a company. Why is inclusion of debt so important? Firstly, debt has a cost that is lower than the cost of equity. Thus inclusion of debt reduces your overall cost of capital and therefore makes your capital structure more optimal. But leverage also has a risk. Payment of principal and interest is a regular commitment and therefore it adds to your financial risk. This risk becomes more pronounced when the market is going through a downturn as you have less of operating profits to service your higher leverage. Financial leverage is therefore a double-edged sword as it has the advantage of reducing your cost of capital but also enhances your bankruptcy risk. It is this balance that is the key to your capital mix.

So, what is financial leverage and how can financial leverage benefit a company. Let us see how judicious use of leverage can help a company’s profits. However, it needs to be remembered that it comes with the risk of bankruptcy vulnerability and lower valuations. The financial leverage formula discussed below will throw more light on these issues!

Degree of Financial Leverage (DFL)
Degree of Financial Leverage (DFL) calculates the sensitivity of the profits of the company to changes in the company’s debt levels and interest costs.

Degree of Financial Leverage (DFL):

Earnings before Interest & Tax (EBIT) / Earnings before taxes

Let us understand the impact of DFL with a live example..

Company B (Year 1)AmountCompany (Year 2)AmountEBIT (a)70,000EBIT (a)70,00010% Bonds (b)-Total Debt (b)200,000Interest Cost (c)-Interest Cost (c)20,000    Earnings before tax70,000Earnings before tax50,000

In the above example, the company has zero debt in the first year but takes on debt in the second year. As a result of the debt, the company incurs an interest cost in the second year. To understand DFL, let us look at a scenario where EBIT moves up by 20% as under..

Company B (Year 1)AmountCompany (Year 2)AmountEBIT (a)84,000EBIT (a)84,00010% Bonds (b)-Total Debt (b)200,000Interest Cost (c)-Interest Cost (c)20,000    Earnings before tax84,000Earnings before tax64,000

In the first year, if EBIT was 20% higher, the EBT would also be 20% higher due to zero debt. However, in the second year, a 20% increase in EBIT levels results in a 28% increase in EBT. That is due to the impact of borrowing which results in fixed interest costs. Companies that borrow are able to show better growth in profits due to the impact of DFL. However, there are 3 things you need to understand here..

The higher growth shown in profits due to leverage is more due to the lower base effect. The rupee growth in net profits is the same in both years. The Difference is that due to interest cost the same profit growth is showing up on a lower base. This is something you need to be conscious of.

Higher leverage entails higher bankruptcy risk and we have seen many companies in the steel, infrastructure and textile sectors pay a huge price for reckless borrowing in the last 10 years. In fact, if banks write off these loans it may actually impel companies to continue to borrow recklessly and create moral hazard.

From a valuations perspective, the preference is always for the companies with the lower leverage. Markets are averse to debt and you will typically find that companies with lower levels of debt tend to get better ROEs and also better P/E ratios in the market. One of the reasons the mid cap companies have fared better than large caps in the last 3 years in India is their lower levels of leverage.

Degree of Total Leverage (DTL)
The Degree of Total Leverage (DTL) is a combination of the impact of Degree of Operating  Leverage (DOL) and the Degree of Financial Leverage (DFL). DTL measures the proportionate change in net profits as a result of a change in revenues. When the company has a high level of DOL and DTL, it automatically has a high degree of DTL too. In such cases, a small percentage change in revenues can trigger a fairly large shift in net profits. But remember the important risk factors here. Higher DOL means that you need to continue to earn a healthy contribution on your core business to cover your fixed costs. Higher DFL will also mean that you need to keep your cost of debt low and ensure that your interest coverage is comfortable enough to service your debt. That is the key to this discussion!

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