Analysis Of Using Leverage And Its Effects

Published Date: 02 Nov 2017

It is the use of debt by a firm to finance its investments. Companies usually leverage with an aim of increasing returns on stocks.

A firm with significantly more debt than equity is considered to be highly leveraged. 

Leverage helps both the investor and the firm to invest or operate. But, it comes with greater risk.

A company tries to generate shareholder wealth using leverage, but if it fails to do so, the interest expense and credit risk of default can also destroy shareholder value.

Leverage arises from the existence of fixed costs. There are 2 kinds of leverage:

Operating Leverage: which arises from the firm’s fixed operating costs such as salaries, depreciation, insurance, property taxes, and advertising outlays.

Financial Leverage: which arises from the firm’s fixed financing costs such as interest on debt. Financial leverage takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest.

Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity.

For example, if a company formed with an investment of $3.5 million from investors, the equity in the company is $3.5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $21 million, the company now has $24.5 million to invest in business operations and thus, will have more opportunity to increase value for shareholders. 

While operating leverage arises from the existence of fixed operating costs, financial leverage emanates from the existence of fixed interest expenses. When a firm has fixed interest expenses, 1% change in PBIT leads to more than 1% change in PBT (or profit after tax or earnings per share).

Degree of Financial Leverage (DFL)

Financial Leverage affects the Earnings per Share (EPS) of the firm. DFL is defined as the percentage change in EPS for a given percentage change in EBIT. The formula is as follows:

DFL = =

Financial leverage = 1/Equity Ratio. The sensitivity of profit before tax to changes in PBIT is referred to as the DFL.

RATIO ANALYSIS

The commonly used ratios are:

Interest Coverage Ratio:

This ratio is used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period:

ICR =

An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses.

Example:

Limitations:

Concerns only with interest burden, ignoring the principal repayment obligation.

It is the measure of earnings, not a measure of cash flow.

It is difficult to establish a norm with this ratio or identify benchmarks.

Cash Flow Coverage Ratio

It is given by:

CFC Ratio =

However, in the given formula, the Loan repayment amount is divided by the tax factor, because, unlike the Interest on Debt, the Loan repayment amount is non tax-deductible.

This ratio is comparatively better than Interest Coverage Ratio as in contrast to it, it takes into account the debt service burden as well as it focuses on cash flows. However, it has gotten much characterized as it tries to establish norms to check its adequacy.

C. Debt Service Coverage Ratio:

Financial institutions use this ratio in order to check the Debt servicing ability of the firm . It is given as:

In general, it is calculated by: 

DSCR =

A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say 0.75, would mean that there is only enough net operating income to cover 75% of annual debt payments. 

Financial institutions regard a Debt Service Coverage Ratio of 1.5 to 1.75 as satisfactory. In case the ratio is below 1.5 and the project is still desirable.

CASH FLOW ANALYSIS:

The main criteria in assessing the debt capacity of a firm is the probability of default associated with a certain level of debt is acceptable to the management. The cash flow approach establishes the debt capacity by examining the probability of default using the following steps:

1. Tolerance limit: the probability of default, which is actually a reflection of how much risk the management is willing to take in terms of default on its debt.

2. Estimation of probability distribution of cash flows: by considering the projected performance of the firm.

3. Calculation of fixed charges in terms of interest and principal amount associated with various levels of debt.

4. Finally, estimate the debt capacity of the firm as the highest level of debt acceptable.

LIMITATIONS:

• Estimation of distribution of operating cash flow is difficult for firms in industries which are dynamic in nature.

• This is a very conservative approach and assumes the firm to rely on its cash balance and operating cash inflows but not on external financing to serve any debt.

• The tolerance limit is very subjective in nature, as in, in management would decide to borrow so as to have a zero probability of default but this may be unacceptable to the shareholders.

COMPARATIVE ANALYSIS:

A common approach to analyze a firm's capital structure could be to compare its debt-ratio with that of other firms or may be, to compare it with the industry average. However, there are some limitations. Firms within the same industry may not be acceptable due to differences in size, capital intensity, operating risks, tax status or product mix etc. Also, the industry average may not really represent the optimum average debt ratio for the industry.