Leverage Analysis
Unit 3
Financial Management
Capital Structure Defined
• The term capital structure is used to represent the
proportionate relationship between debt and equity.
• The various means of financing represent the financial
structure of an enterprise. The left-hand side of the
balance sheet (liabilities plus equity) represents the
financial structure of a company. Traditionally, short-
term borrowings are excluded from the list of methods
of financing the firm’s capital expenditure.
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The capital structure decision process
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While making the Financing Decision...
• How should the investment project be financed?
• Does the way in which the investment projects are
financed matter?
• How does financing affect the shareholders’ risk, return
and value?
• Does there exist an optimum financing mix in terms of the
maximum value to the firm’s shareholders?
• Can the optimum financing mix be determined in practice
for a company?
• What factors in practice should a company consider in
designing its financing policy?
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Meaning of Financial Leverage
• The use of the fixed-charges sources of funds, such as debt and
preference capital along with the owners’ equity in the capital
structure, is described as financial leverage or gearing or trading
on equity.
• The financial leverage employed by a company is intended to
earn more return on the fixed-charge funds than their costs. The
surplus (or deficit) will increase (or decrease) the return on the
owners’ equity. The rate of return on the owners’ equity is
levered above or below the rate of return on total assets.
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Measures of Financial Leverage
• Debt ratio
• Debt–equity ratio
• Interest coverage
• The first two measures of financial leverage can be
expressed either in terms of book values or market values.
These two measures are also known as measures of
capital gearing.
• The third measure of financial leverage, commonly known
as coverage ratio. The reciprocal of interest coverage is a
measure of the firm’s income gearing.
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Financial Leverage and the
Shareholders’ Return
• The primary motive of a company in using financial leverage is
to magnify the shareholders’ return under favourable
economic conditions. The role of financial leverage in
magnifying the return of the shareholders’ is based on the
assumptions that the fixed-charges funds (such as the loan
from financial institutions and banks or debentures) can be
obtained at a cost lower than the firm’s rate of return on net
assets (RONA or ROI).
• EPS, ROE and ROI are the important figures for analysing the
impact of financial leverage.
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EPS and ROE Calculations
• For calculating ROE either the book value or the market
value equity may be used.
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Effect of Leverage on ROE and EPS
Favourable ROI > i
Unfavourable ROI < i
Neutral ROI = i
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Leverage Analysis
• This analysis is conducted to understand the
level of risk associated with the financing
decision
• It gives the magnitude of change in one
variable due to change in another variable
• Leverage =
• There are three types of leverages
• Operating Leverage
• Financial Leverage
• Combined Levwerage
Degree of Operating Leverage
• Operating leverage affects
a firm’s operating profit
(EBIT).
• The degree of operating % Change in EBIT
leverage (DOL) is defined DOL
% Change in Sales
as the percentage change
in the earnings before EBIT/EBIT
DOL
interest and taxes relative Sales/Sales
to a given percentage
change in sales.
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• Operating leverage can be defined as the
degree of change in the level of EBIT due to a
change in sales Operating leverage occurs due
to presence of fixed operating cost in the
business . It can also be calculated by an
alternate formula : .
Contribution /EBIT
The higher the fixed cost ,the higher will be the
DOL and therefore higher the operating risk
Degree of Financial Leverage
• The degree of financial leverage (DFL) is
defined as the percentage change in EPS due
to a given percentage change in EBIT:
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• Financial Leverage is the change in the level of
EPS due to change in EBIT
• Financial leverage occurs die to presence of
Fixed financial cost ( Interest ) in the business
• Alternate formula for calculating DFL is
EBIT/EBT
• Lets take an example of a company A whose
data is taken for two periods of time
Particulars Period 1 Period 2
Sales 100 110
Less : Variable 40 44
Cost (40%of
sales)
Contribution 60 66
Less: Fixed 20 20
Cost
EBIT 40 46
• Using the formula for DOL, the result is 1.5
which means that for every 1 % change in
sales the EBIT will change 1.5% . I.e. the
magnitude of change will be more than in
proportion . But ,if there are no fixed cost
then the DOL will be 1 which means that if the
sales change by 1% the EBIT will also change
by 1 %
Combining Financial and Operating
Leverages
• Operating leverage affects a firm’s operating
profit (EBIT), while financial leverage affects
profit after tax or the earnings per share.
• The degrees of operating and financial
leverages is combined to see the effect of
total leverage on EPS associated with a given
change in sales.
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Combining Financial and Operating
Leverages
• The degree of combined leverage (DCL) is
given by the following equation:
% Change in EBIT % Change in EPS % Change in EPS
% Change in Sales % Change in EBIT % Change in Sales
• another way of expressing the degree of
combined leverage is as follows:
Q( s v) Q( s v) F Q( s v)
DCL
Q( s v) F Q( s v) F INT Q( s v) F INT
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Financial Leverage and the
Shareholders’ Risk
• The variability of EBIT and EPS distinguish between two
types of risk—operating risk and financial risk.
• Operating risk can be defined as the variability of EBIT (or
return on total assets). The environment—internal and
external—in which a firm operates determines the
variability of EBIT
– The variability of EBIT has two components:
– variability of sales
– variability of expenses
• The variability of EPS caused by the use of financial
leverage is called financial risk. Financial risk is an
avoidable risk if the firm decides not to use any debt in its
capital structure.
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Risk-Return Trade-off
• If the firm wants higher return (EPS or ROE) for the
shareholders for a given level of EBIT, it will have to employ
more debt and will also be exposed to greater risk (as
measured by standard deviation or coefficient of variation).
• In fact, the firm faces a trade-off between risk and return.
• Financial leverage increases the chance or probability of
insolvency.
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