1. Chapter Introduction
2. Leverage: Meaning
3. Risk & Financial Leverage
4. Relationship: Financial and Operating leverage
1. Chapter Introduction:
In this chapter, you will get an idea about the basic concept of leverage and will be exposed to the role and effects of financial leverage. Leverage ratios reflect the solvency status of a firm.
2. Leverage: Meaning:
Capital structure decisions aims at determining the types of funds a company should seek to finance its investment opportunity and the preparation in which these funds should be raised. The term capital structure is used to represent the proportionate relationship between the various long-term forms of financing such as debentures, long term debts, preference share capital and equity share capital.
Capital Structure and Leverage:
‘Leverage’ is the action of a lever or the mechanical advantage gained by it; it also means ‘effectiveness’ or ‘power’. The common interpretation of leverage is derived from the use or manipulation of a tool or device termed as lever, which provides a substantive clue to the meaning and nature of financial leverage.
When an organization is planning to raise its capital requirements (funds), these may be raised either by issuing debentures and securing long term loan 0r by issuing share-capital. Normally, a company is raising fund from both sources. When funds are raised from debts, the Co. investors will pay interest, which is a definite liability of the company. Whether the company is earning profits or not, it has to pay interest on debts. But one benefit of raising funds from debt is that interest paid on debts is allowed as deduction for income tax. 'When funds are raised by issue of shares (equity) , the investor are paid dividend on their investment. Dividends are paid only when the Company is having sufficient amount of profit. In case of loss, dividends are not paid. But dividend is not allowed as deduction while computing tax on the income of the Company. In this way both way of raising funds are having some advantages and disadvantages. A Company has to decide that what will be its mix of Debt and Equity, considering the liability, cost of funds and expected rate of return on investment of fund. A Company should take a proper decision about such mix, otherwise it will face many financial problems. For the purpose of determination of mix of debt and equity, leverages are calculated and analyzed.
Capital Structure and Financial Structure Distinguished
In finance literature one often finds the terms capital structure and financial structure used interchangeably. Capital structure of firm represents the proportionate relationship between the various long-term forms of financial while financial structure refers to the way the company’s assets are financed. It is the entire left hand side of the balance sheet, i.e., long term and short term sources of funds. Thus, a firm capital structure refers to the permanent financing pattern and is only a part of its financial structure. An analysis of capital structure involves the use of financial leverage factor.
Concept of Financial Leverage (June 03)
Leverage may be defined as the employment of an asset or funds for which the firm pays a fixed cost or fixed return. The fixed cost or return may, therefore be thought of as the full annum of a lever. Financial leverage implies the use of funds carrying fixed commitment charge with the objective of increasing returns to equity shareholders. Financial leverage or leverage factor is defined, as the ratio of total value of debt to total assets or the total value of the firm. For example, a firm having a total value of Rs. 2,00,000 and a total debt of Rs. 1,00,000 would have a leverage factor of 50 percent. There are difficult measures of leverage such as.
- The ratio of debt to total capital
- The ratio of debt to equity
- The ratio of net operating income (earning before interest and taxes) to fixed' charges) The first two measures of leverage can be expressed either in book v8lue or market value the debt of equity ratio as a measure of financial leverage is more popular in practice. "
3. Risk & Financial Leverage:
Q. ‘Risk increases proportionally with financial leverage’. Refute this statement with suitable reasons. (Jan. 01)
Effects of financial Leverage: The use of leverage results in two obvious effects:
- Increasing the shareholders earning under favorable economic conditions, and
- Increasing the financial risk of the firm. Suppose there are two companies each having a Rs. 1,00,000 capital structure. One company has borrowed half of its investment while the other company has only equity capital: Both earn Rs. 2,00,000 profit. The ratio of interest on the borrowed capital is 10%and the rate of corporate tax 50%. Let us calculate the effect of financial leverage, both in the shareholders earnings and the Company's financial risk in these two companies.
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Company A
Rs. |
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Company B
Rs. |
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Profit before Interest and Taxes |
2,00,000 |
2,00,000 |
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Equity |
10,00,000 |
5,00,000 |
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Debt |
---- |
5,00,000 |
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Interest (10%) |
---- |
50,000 |
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Profit after interest but before Tax |
2,00,000 |
1,50,000 |
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Taxes @ 50% |
1,00,000 |
75,000 |
Rate of return on Equity of Company B Rs. 75,000/Rs. 5,00,000 = 15%
The above illustration points to the favorable effect of the leverage factor on earnings of shareholders. The concept of leverage is 5 if one can earn more on the borrowed money that it costs but detrimental to the man who fails to do so far there is such a thing as a negative leverage i.e. borrowing money at 10% to find that, it can earn 5%. The difference comes out of the shareholders equity so leverage can be a double-edged sword.
(b) Effect of Leverage on the financial risk of the company: Financial risk broadly defined includes both the risk of possible insolvency and the changes in the earnings available to equity shareholders. How does the leverage factor leads to the risk possible insolvency is self-explanatory. As defined earlier the inclusion of more and more debt in capital structure leads to increased fixed commitment charges on the part of the firm as the firm continues to lever itself, the changes of cash insolvency leading' to legal bankruptcy increase because the financial 'charges incurred, by the firm exceed the expected earnings. Obviously this leads to fluctuations in earnings' available to the equity shareholders.
4. Relationship: Financial and Operating leverage:
Relationship between financial and operating leverage: In business terminology, leverage is used in two senses: Financial leverage & Operating Leverage
Financial leverage: The effect which the use of debt funds produces on returns is called financial leverage.
Operating leverage: Operating leverage refers to the use of fixed costs in the operation of the firm. A firm has a high degree of operating leverage if it employs a greater amount of fixed costs. The degree of operating leverage may be defined as the percentage change in profit resulting from a percentage change in sales. This can be expressed as:
= Percent Change in Profit/Percent Change in Sales
The degree of financial leverage is defined as the percent change in earnings available to common shareholders that is associated with a given percentage change in EBIT. Thus, operating leverage affects EBIT while financial leverage affects earnings after interest and taxes the earnings available to equity shareholders. For this reason operating leverage is sometimes referred to as first stage leverage and financial leverage as second stage leverage. Therefore, if a firm uses a considerable amount of both operating leverage and financial leverage even small changes in the level of sales will produce wide fluctuations in earnings per share (EPS). The combined effect of both these types of leverages is after called total leverage which, is closely tied to the firm's total risk.