Are you wondering how companies use borrowed money to boost their profits?
That’s where financial leverage comes in. Financial leverage involves using debt to finance assets and operations to boost returns. Knowing the right amount of debt is key to assessing a company’s financial health and its ability to profit from borrowing.
In this article, we’ll break down what financial leverage is, how to calculate it, what it means for businesses, and how to manage the risks involved.
What you’ll learn
What is the Degree of Financial Leverage?
The DFL established how vulnerable the company’s earnings per share (EPS) were to change in operating income as a result of changes in capital structure, particularly the use of debt. It captures the manner in which EPS is affected by operating income changes occasioned by fixed-cost financing instruments such as debt. DFL enables the investors and the analysts to evaluate the impact of the financial leverage on the profitability and the risks of the business.
DFL is obtained by using the formula, the percentage change in EPS divided by the percentage change in operating income. A high DFL means that a small change in operating income can lead to a larger change in EPS, in other words, high financial risk. On the other hand, a low DFL indicates that EPS has less fluctuations with change in operating income, therefore lower financial risk.
It is important to evaluate DFL in order to determine the financial position of a company. It shows the advantages and disadvantages that are connected with the use of debt. Low interest bearing debt is good for high financial leverage when operating income is high, exciting to investors who are interested in higher returns. However, it has increased the risk of the company since operating income decline sharply pulled down the EPS affecting the financial health of the company.
In this context, analysis of DFL will allow for a more effective assessment of a company’s financial plan, its exposure to risks, and its investment attractiveness. DFL is essential in risk and return analysis, whereby firms can determine the right proportion of debt and equity to adopt in its capital structure that will ensure sustainable growth and at the same time control for financial risks.
Understanding Financial Leverage
Financial leverage is a situation whereby an organization uses other people’s money to acquire assets or run the business with the intention of realizing higher returns. Companies use debt with the view of earning higher returns than could be obtained through the firm’s own resources. However, this approach has its drawbacks, especially systematic risk that occurs to all the firms as a result of economic changes.
The basic principle of financial leverage is simple: receive more from the investment than the cost that is incurred through the borrowing. This can lead to higher profits, in case the investments are successful because returns from these investments are distributed among the equity holders. But, it also enhances the possibility of making losses in the process. When investments under-perform, the company is still bound to meet its interest and principal payments on the debt which put pressure on cash flow. This could in extreme cases lead to a margin call where the investor is forced to provide more collateral to meet the loss.
Leverage also assists in the correct financing mix as a company in a bid to reduce the cost of capital assets. One advantage is that the interest charged on the debt is tax on the other hand, dividends on equity are tax, which is advantageous.
What Does Degree of Financial Leverage Tell You?
The DFL shows a company’s risk and returns from operations for a given amount of fixed cost financing such as debt impacting EPS for every operation income variation. A higher DFL means more use of debt, which in turn means a higher leverage – or increase in both the profits and the losses.
DFL is used in evaluating the risk that is inherent in the capital structure of a particular firm. High financial leverage thus implies that the firm is exposed to fluctuations in operating income because even if total revenues fluctuate, total costs for interest do not. Decline in operating income does not bring down these costs and therefore, a steeper decline in net income and EPS is observed. Therefore, it can be inferred that a high DFL indicates a higher risk of financial distress particularly during economic downturn or in sales volatility.
On the other hand, DFL also reveals that there exist higher returns for the firms. This is because fixed debt costs imply that as more revenues are earned, net income is boosted, thereby expediting the EPS growth rate. Leverage has the effect of potentially large profits in a favorable environment as demonstrated by the above companies.
Leveraging requires that one manages the risks associated with it while at the same time exploiting the benefits. As it can improve the returns on investment it also increases the risk factor of the financial investment. Organizations need to evaluate their capability to generate and maintain operating income for fixed costs. The optimal DFL is one that achieves maximum returns with acceptable level of risks in light of revenue predictability, costs of debt and state of the economy.
Altogether, DFL offers information about financial condition, the possibility of getting a high profit or loss, and influencing the Company’s financing decisions.
Formula for Degree of Financial Leverage
The degree of operating lease leverage (DOFL) analyzes the effect of fixed operating lease costs on the earnings of an organization. It demonstrates how modifications in operating income (EBIT) influence net income and provides understanding of the financial risk associated with the firm’s capital structure.
Financial leverage is the use of debt to finance assets in an organization’s balance sheet with the view of increasing the rate of returns on equity. Debt also brings in interest as a sunk cost and this makes the impact of any changes in EBIT on net income even bigger.
To calculate the degree of financial leverage, we use the following formula:
Let’s break down each component of the formula in simple terms:
- EBIT (Earnings Before Interest and Taxes): This is the company’s operating income before accounting for interest expenses and taxes. It reflects the profit generated from the company’s core business operations.
- Interest: This represents the total interest expenses the company incurs on its outstanding debt. Interest is a fixed financial cost that the company must pay regardless of its operating performance.
For example, consider a company with an EBIT of $500,000 and interest expenses of $100,000. Using the formula, we get:
DFL = 500,000 / 500,000 – 100,000 = 500,000 / 400,000 = 1.25
This DFL of 1.25 means that for every 1% change in EBIT, EPS will change by 1.25%.
A higher DFL indicates that net income is more sensitive to changes in EBIT, showing higher financial leverage. Understanding DFL helps investors and managers assess how debt affects financial performance, balancing potential rewards against risks, and guiding strategic financial decisions.
Example of Degree of Financial Leverage
To explain the degree of financial leverage let us consider an example with the help of Peloton’s data.
Companies such as Peloton which recorded high growth during the early months of the COVID-19 pandemic leveraged on debt to finance their growth. This led to some very high interest expenses which greatly affected the EBIT of the company. The DFL enables us to comprehend how these fixed interest costs impact on fluctuations of net income compared to fluctuations of EBIT. For instance, if the DFL is 2, then it means that you get 2 times the free capital. , meaning that for a 1% change in EBIT, the net income will change by 2% thereby illustrating the effect of financial leverage.
Scenario 1: EBIT Increases
During the same year, as the demand for home fitness equipment rose, Peloton’s EBIT rose considerably. This rise when combined with its high DFL had a resultant effect on net income which rose at a much faster rate. The company used fixed costs to achieve higher levels of profitability and illustrate how financial leverage can improve the business returns when it experiences growth.
Scenario 2: EBIT Decreases
While in the year 2022, the same organization was struggling with its demand and operational issues. Lower EBIT along with high fixed costs, derived from debts, resulted in the decline of net income which indicated that high leverage is risky. This scenario brought out the dangers of using financial leverage during periods of low revenue source.
These examples demonstrate the dual nature of financial leverage: it can amplify profits during good conditions and similarly magnify losses when circumstances worsen. Knowledge of DFL is crucial for assessing the risk premium associated with a company’s capital structure, as it influences both the potential rewards and the risks of debt use.
Impact of Financial Leverage on Company Performance
A high DFL can greatly impact a company’s profitability and risk. It can boost returns on equity but also increases exposure to downside risk. Highly leveraged companies are particularly vulnerable to drops in operating income since their fixed costs remain constant.
However, when the operating income of the company is increasing, then the high financial leverage can be useful. Since the interest expenses on debts are fixed more of the increase in EBIT leads to increase in net income. This improves the return on equity and the profitability which makes high leverage desirable during the growth phase. For instance, a rise in the EBIT by 10% can lead to a much higher percentage increase in the net income thereby giving better returns to shareholders.
However, high financial leverage also increases the negative impact of reducing EBIT. During recession or when the company records poor performance, the fixed interest costs pose a big problem. A decline in EBIT affects the net income even to a larger extent due to the use of leverage that results in financial distress. For instance, a 10% decline in EBIT can lead to a much larger drop in net income, including negative values and, therefore, financial insecurity.`
Therefore, while the use of high amounts of financial leverage is likely to increase profitability during favorable conditions, it implies higher risk. Leverage is a great risk that calls for steady and strong operating income to be managed in companies that have high leverage. On the other hand, the companies with low leverage may have steady, but relatively lower, returns on their investments. Financial leverage, therefore, has to be managed efficiently and planned for in the right manner to control for the risks involved.
Risk Management with Financial Leverage
Hence, it is crucial to balance the risks arising from high financial leverage for the stability of a company’s finances. It is possible to reduce negative effects and make sure that using leverage leads to increased profits without putting pressure on the financial situation.
One of the effective measures is ensuring a good cash flow position. Organizations should strive to have smooth cash flows in order to meet the interest charges and the redemption of the debts. This can be done through proper management of working capital, improving operating efficiency to cut on expenses and ensuring a good and steady cash inflow. Effective cash flow management is a protective shield against fluctuations in the economy and other costs that might arise from time to time.
Another practice is to avoid having all of the debt due at the same time, that is, to have long-term and short-term debts. Hedging also involves the management of maturity profiles, which means that companies do not have to refinance large amounts of money at any one time, especially when the market is unfavorable. This minimizes the possibility of liquidity problems and provides for more reasonable terms of repaying the credit. Additionally, investors can use real-time stock alerts as a supplementary tool to stay updated on market conditions, helping them make timely adjustments to their debt management strategies.
Another aspect is hedging of the interest rate risk. Some examples of derivatives that can be used by companies are the interest rate swaps and options as a hedge against fixed rates or future rate hikes. This assists in maintaining the cost of servicing the debt low and constant in the event that market rates go up thus stabilizing cash flows.
It is important not to have too much leverage, and therefore, a debt to equity ratio should be kept moderate. Debt on the other hand is a better hedge against risks and the firm uses it while also maintaining a healthy stock of equity. This balance is achieved through the process of reviewing and changing capital structure periodically depending on the market conditions.
Last but not the least, one has to ensure strict compliance with financial planning and forecasting processes. Updating the financial models and stress testing as well as conducting the sensitivity analysis is very useful in order to identify and prepare for the risks. Such an approach helps to be ready for the unfavorable situation and make changes in the strategy when necessary.
In this way, the companies are able to control the risks associated with high financial leverage, while at the same time getting the benefits that this leverage offers.
Conclusion
It is therefore important for any firm with an interest in the level of financial leverage to make the necessary effort to acquire this knowledge. The use of debt intelligently can improve return and growth of a firm while at the same time poses some risks that need to be well managed and planned for to avoid financial stress.
Measures like healthy cash flows, long-term borrowing, and the use of instruments that would guard against changes in rates of interest will help minimize the risks associated with the use of high levels of leverage. These strategies assist in maintaining financial stability in the uncertain economic conditions so that the companies can capture the benefits out of it without high risk involved.
Deciphering the Degree of Financial Leverage: FAQs
What Aspects Should Be Taken into Consideration While Evaluating the Level of Financial Risk?
Some of the factors may include the company’s current debts, its interest coverage ratio, earnings volatility, cash flows and its ability to meet its interest obligations. Other factors that should not be overlooked include economic factors and industry specific risks that may impact on the health of the company’s finances.
What is the Cross Sectional Distribution of the Degree of Financial Leverage?
This is because financial leverage differs from one industry to another depending on capital structure, revenue predictability and operational risks. For instance, the leverage is likely to be high among utility companies or other companies with stable cash flows compared with technology companies that are likely to have low leverage due to fluctuating revenues. It is only when these characteristics unique to the industry are well understood that accurate leverage analysis is possible.
What Signals Should Indicate That It Is High Time to Turn to Financial Leverage?
Some of the signs include high DE ratio, declining ICR, and problems in generating enough cash to meet its obligations. Other signs include; high frequency of refinancing, increase in the cost of borrowing as well as credit rating downgrades. Another signal is the so-called aggressive accounting that can be used to mask the financial difficulties.
What Does the Financial Leverage Indicator Tell Small Investors?
Leverage can be defined by small investors through financial statements and ratios such as debt equity, interest coverage and debt to assets and comparing them with the related industry. They should also take the stability and the growth of the company’s earnings into account to assess the risks and the returns of investment.
Which Fluctuations in Financial Leverage Indicators Should Attract the Attention of the Company’s Management?
Management should be cautious if there is an increase in the level of debt without a corresponding increase in revenue or earnings, declining interest coverage ratio, negative changes in cash flow, declining credit ratings, and increasing borrowing costs as these are signs of financial distress.
