Modigliani, Miller, David Durand, and many other financial scientists focused their areas of interest on the firms’ capital structure. From small enterprises to partnerships and multinational organizations, the capital structure of different companies within the same industries varies. Capital structure can be defined as the distribution of the equity(owner-financed) and debt (borrowed money) in the firm’s capital.
The capital structure of a firm impacts several strategic and financial decisions of a company. Not just this, it also helps the external stakeholders to analyze the financial health of a business entity. For instance, the prospective creditor will analyze the financial ratios related to capital structure when issuing the loan. Further, the shareholders also consider the composition of a firm’s capital structure to predict prospects.
In this article, we are going to discuss the debt part of any firm’s capital structure. It is also called leverage financial leverage. We will discuss the definition, example, benefits, and limitations of financial leverage.
What Is Financial Leverage?
Financial leverage is defined as using borrowed money to finance business operations in a business entity. The financial leverage or financial gearing is the percentage of debt as compared to the owner’s equity in the capital structure of the business entity.
Depending on the size and type of the business entity, the financial leverage can be represented in bank loans, debentures, debt securities, or accounts payables. If we look closely at the balance sheet of a company, there are two sides. The left-hand side represents the assets owned by the company. The right side shows the owner’s equity and the debt or financial leverage.
How Does Financial Leverage Work?
As discussed earlier, financial leverage is part of the capital. The question arises that why does a business entity choose debt over owner’s equity. By using financial leverage, the companies can finance their capital expenses. However, there is a fixed cost of using debt financing. Besides, many companies also rely on debt financing instead of equity capital to lower taxes.
The financial leverage of any business entity is measured by the ratio of debt to total assets. When the ratio of debt as compared to assets increases, the financial leverage of the business entity also increases.
Positive Or Negative Financial Leverage
Any business entity can have positive financial leverage or negative financial leverage. Let’s understand how does positive or negative financial leverage works.
Since the financial leverage is used to finance the additional assets for a business entity, the positive or negative financial leverage also relates to it. When the return on the assets acquired by the loan is greater than the loan’s interest rate, the company has positive financial leverage. By using a lower debt level, the company is achieving more value.
On the other hand, if the return on the assets acquired by the loan is lower than the interest rate on the loan, the company experiences negative financial leverage.
For instance, if a company’s long-term debt has a 12% interest rate per annum. The after-tax rate of return is around 15%. The interest rate on a loan is tax-deductible. Therefore, the after-tax interest rate will be calculated as follow:
After-tax interest rate = interest rate X (1 – tax rate)
After-tax interest rate = 12% X (1-0.4)
After-tax interest rate = 7.2%
In this case, the benefit to the common shareholders will be the difference between the after-tax return and interest rate.
How To Calculate Financial Leverage?
The financial leverage is often calculated as the debt to assets ratio. The formula for the debt-to-asset ratio is as follow:
Let’s comprehend it with the help of an example.
Debt to Assets Ratio = Long-term debt / Total Assets
Michael & Sons is in the business of manufacturing. The company has purchased a manufacturing unit on cash with equity financing.
The cost of purchase was 1 million USD. The monthly revenues from the purchase are 15,000 USD. The company has not used any debt, so the financial leverage of the company is zero.
On the other hand, there is another company, Lotter Manufacturing Inc. the company has used 10% equity and 90% debt to buy a similar manufacturing plant. The monthly profits of the second company are also around 20,000 USD. Since Lotter Inc. uses financial leverage, they also incur expenses at the rate of interest.
In this example, the second company is generating a profit of 180,000 USD per annum on investment of 100,000 USD. The return rate on investment is 180% of the original investment.
The business entities leverage financial leverage to earn a higher return on their investments. However, if things do not go well, the impact is amplified in the losses too.
Importance Of Financial Leverage
We can sum up the importance of the financial leverage for a business entity as follow:
- Financial leverage is a management tool companies use to make capital budgeting and strategic decision-making about different investment opportunities.
- Debt is an important part of a firm’s capital structure. By using financial leverage, the companies have access to more than one source of financing for their business operations and capital expenditures.
- The finance experts look at financial leverage as a useful technique of investing that enables companies to analyze different opportunities. Besides, financial leverage can be used to set minimum thresholds for investing in any opportunity. A business entity can set a threshold of rejecting any opportunity giving a return lower than the cost of borrowed capital.
Different Measures Of Financial Leverage
Every financial metric of a business entity is employed for further analysis, be it ratio analysis or qualitative analysis. Similarly, a business entity’s financial leverage or debt level can also be used for further analysis and various financial ratios. The most common financial ratios that employ the financial leverage of a business entity are as follows.
The debt to equity ratio is similar to the debt to total assets ratio. However, in the debt-to-equity ratio, the total long-term debt of a business entity is compared with the shareholder’s equity. For instance, in the above example, the second company used 10% equity and 90% debt.
The debt-to-equity ratio is also represented as the financial leverage of a business entity. If a firm has 0.5USD debt for every 1USD of equity, it will have a 50% debt-to-equity ratio.
The formula for debt to equity ratio is as follow:
Debt to Equity Ratio = Long-term debt / Shareholder’s equity
Degree Of Financial Leverage
The degree of financial leverage is also a financial ratio that is used to highlight the change in a business’s profitability by the change in its capital structure.
More simply, the degree of financial leverage measures how every 1USD of debt in the firm’s capital impacts the company’s operating profit. You can call it the sensitivity of profitability to the changes in capital structure.
The degree of financial leverage can be measured by using the following formula:
Degree of Financial Leverage = % Change in Net Income / % Change in EBIT
The following formula can also measure the degree of financial leverage per share:
Degree of Financial Leverage = % Change in the Earning Per Share / % Change in EBIT
*EBIT = Earnings before interest and tax
Interest Coverage Ratio
The interest coverage ratio measures how well a business entity can pay the interest due on the debt. It is also called as times interest earned ratio. The external stakeholders, creditors, use the interest coverage ratio for the risk assessment at the time of lending the capital to any business entity.
The time’s interest earned ratio can be measured by the following formula:
Times Interest Earned Ratio = Earning Before Interest and Tax / Total Interest Expense
Benefits Of Financial Leverage
We have already discussed the importance of financial leverage for any business entity. Let’s look at the benefits of financial leverage for any company.
Increases the Availability Of Money To The Business Entity
The prospects are limited when the company has to invest the business operations or capital expenditures by the shareholder’s equity. The use of financial leverage enables business entities to leverage profitable business opportunities without having too much cash. In other words, financial leverage opens the doors of many opportunities for any business entity.
Higher Shareholder’s Profit
As discussed earlier, financial leverage improves the shareholder’s profit. The companies using financial leverage have better profitability for shareholders than those using equity financing only. The increase in profitability of a company using financial leverage is higher than the increase in stock’s value or dividend.
For instance, if the company earns 5% profit, the shareholders will get only 5% if the company does not uses financial leverage. However, in the other case, the improved profitability is due to debt, and shareholders can enjoy higher profitability.
Helps Improve Credit Rating
One bad event can damage a company’s credit rating and make it difficult to get future debt financing. However, business entities can use financial leverage to improve their credit rating. Taking small amounts of debts from different creditors and paying the interest rate consistently on time will considerably improve the overall credit rating of the business entity.
In a nutshell, financial leverage is not a financial measure that has all the good aspects and no downsides. There are many risks involved in using financial leverage too. For instance, if the profits are maximized, the losses are amplified too. Therefore, the business entities should use the financial leverage smartly to finance their capital expenditures.