Financial Leverage

Glossary Lever: A rigid bar pivoted on a fixed point (i.e., a fulcrum) and used to transmit force, as in raising or moving a weight at one end by pushing down on the other. The power of a lever is created by the relationship of the distances on either side of the fulcrum, e.g., a distance of 4 feet on one side of the fulcrum to 1 foot on the other side. The magnification of the downward force is then 4 times - anything slightly greater than a 10-pound force will raise a 40-pound weight. It is this idea of magnification, or multiplying of a force, that gives operating leverage its name. Financial leverage: A magnification of profits (net income or earnings after taxes, or EAT) that results from having fixed financial costs in the company. Financial leverage increases as the fixed financial expenses increase (i.e., as interest expense increases with the greater use of debt). With a high level of debt relative to equity, a small percentage change in EBIT (defined below) will lead to a large percentage change in net income. In other words, the percentage increase in EBIT is magnified. Technically, financial leverage is defined as the percentage change in EAT divided by the percentage change in EBIT. Fixed financial expenses: Financial expenses that do not change with the level of production. The two usual financial expenses are interest and taxes. Of these two, only interest is a fixed expense. Variable financial expenses: Financial expenses that change with the level of production. As sales (and production) increase, taxable income normally increases; therefore, taxes tend to increase as production and sales increase. Taxes are viewed as a variable financial expense. Breakeven point: The level of sales where a company's revenues equal its costs. Profit is zero at the breakeven point. EBIT: Earnings Before Interest and Taxes. On a income statement, it is equal to Sales minus Operating Expenses. Accountants generally refer to this number as Net Operating Income (i.e., the income left over after subtracting operating expenses). Finance practitioners generally call

the same number EBIT (i.e., the income on an income statement before subtracting interest and taxes).

We all deal with financial leverage every day. We borrow money on student loans and use that investment to help us earn a higher income in our career. We borrow money to buy a home and end up with large profits. We borrow money from our stock broker and use it to purchase common stock (a process known as buying on margin). An Example of Financial Leverage As an example, assume that you purchase a $100,000 house. You put up $20,000 of your own money and borrow the remaining $80,000. The interest rate on the loan is 5% per year. Also assume that the loan is interest-only, i.e., you do not pay off any of the principal each year; you only pay the interest that is due. Let's also assume that the market price of your home appreciates by 10% per year. Looking at the table below, notice that the value of your home at the beginning of the first year of ownership is $100,000. If it appreciates 10% that year, the value of the home at the end of the year will be $110,000, for a total profit of $10,000. However, you must pay interest of 5% on the $80,000 loan, for a total of $4,000 interest. Deducting this from the $10,000 profit, you have a net profit of $6,000 for the year. Since you invested $20,000 of your own money, your profit is $6,000/$20,000 or a 30% rate of return. For the second year, your appreciation is 10% of $110,000, or $11,000. Deducting the interest of $4,000 yields a net profit of $7,000, for a 35% rate of return based on your $20,000 investment. Notice that, even though the appreciation in the value of the home is 10%, your rate of return each year exceeds 30%. This magnification of return is due to the fact that you borrowed money at a rate of 5% and invested the borrowed money to earn a rate of 10% per year. As long as you invest the money for more than the interest rate that you're paying, you will get a positive magnification in the rate of return. This is known as positive financial leverage. Value at Value at Beginning of End of Cumulative Year Appreciation Year Interest Profit Profit 100,000 10,000 110,000 4,000 6,000 6,000 110,000 11,000 121,000 4,000 7,000 13,000 121,000 12,100 133,100 4,000 8,100 21,100 133,100 13,310 146,410 4,000 9,310 30,410 146,410 14,641 161,051 4,000 10,641 41,051 161,051 16,105 177,156 4,000 12,105 53,156 177,156 17,716 194,872 4,000 13,716 66,872

Year 1 2 3 4 5 6 7

% Cumulative Return % Return 30% 30% 35% 65% 41% 106% 47% 152% 53% 205% 61% 266% 69% 334%

8 9 10

194,872 214,359 235,795

19,487 21,436 23,579

214,359 4,000 15,487 82,359 235,795 4,000 17,436 99,795 259,374 4,000 19,579 119,374

77% 87% 98%

412% 499% 597%

Financial leverage is a financial tool that is widely used to improve a company's rate of return. It is not without its risks however. If you borrow the money at a fixed rate of interest, like 5%, and invest the money to earn less than the rate of interest (e.g., 3%), then you will experience negative financial leverage and your losses will be magnified. Notice that in the previous home example, if you could put up the entire $100,000 of your own money (and had borrowed none), you would earn the same rate of return as the appreciation in the price of the home. A 10% appreciation would result in a $10,000 net profit, resulting in a 10% rate of return ($10,000/$100,000). In other words, there would be no magnification of the rate of return on investment. Financial leverage results from having a fixed financial cost (interest) - no fixed financial cost, no magnification. How Can A Company Control the Amount of Financial Leverage? By controlling the amount of debt (relative to the amount of equity). As the ratio of debt to equity increases, the degree of financial leverage increases. Remember that a magnification of profits occurs whenever the company's managers make decisions that add fixed costs to the company. If these managers borrow money at a fixed interest rate, the fixed interest payments will tend to magnify the company's changes in income. As sales and EBIT increase, the interest payments do not change. Therefore, more of this operating cash flow is allowed to flow through to the owners because very little is siphoned off in the form of higher expenses. What is the Relationship Between Financial Leverage and Risk? As the degree of financial leverage increases, the risk to the company increases. As financial leverage increases,

the breakeven point of the company increases. The company now has to sell more of its product (or service) in order to break even. the risk to banks and other lenders increases because of the higher probability of bankruptcy. the risk to stockholders increases because greater losses may be incurred if the company goes bankrupt. the risk to stockholders increases because the higher leverage will cause greater volatility in earnings (and therefore, greater volatility in the stock price).

Is the Degree of Financial Leverage Affected by the Degree of Operating Leverage? Yes, since both types of leverage tend to increase the risk of the company. Therefore, you would normally like to "trade off" the risk of one against the other.

The total leverage of the company is the product of operating leverage and financial leverage, i.e., Total Leverage = Operating Leverage * Financial Leverage Of these three, the desired levels are determined in the order of left to right above: total leverage first, operating leverage second, and financial leverage last. 1. Total leverage determines the overall risk level of the company; this is set by the company's owners (through its board of directors) and is reflected in the operating and financial policies of the company. This decision is made first. 2. The degree of operating leverage is determined next. The company's production manager will determine how the product is to be produced. Will it be produced by using a lot of machinery (i.e., with a high degree of operating leverage) or by using a lot of labor (i.e., with a low degree of operating leverage)? The production manager will make this decision after the board has decided how much overall risk it is comfortable with and before the financial decisions are made. 3. The degree of financial leverage is determined last. How will the company's assets be financed: (1) with a lot of debt and little equity or (2) with very little debt and a lot of equity? The contribution that leverage makes to risk is:

high degrees of leverage lead to a high risk level for the company. average degrees of leverage lead to an average risk level for the company. low degrees of leverage lead to a low risk level of the company.

Scenario #1: If the owners have decided to maintain an average amount of risk (which is usually the case) and the production manager has decided to use a lot of machinery (with their related high fixed operating costs), then the financial manager will need to finance the company with a low degree of financial leverage. The low leverage (financial) offsets the high leverage (operating) yielding an average degree of total leverage (that satisfies the owners). That is, Given that: Total leverage = Operating leverage * Financial leverage Average risk (set by owners) = High risk (production manager) * Low risk (financial manager) Desired leverage level is: Average total leverage = High operating leverage * Low financial leverage Scenario #2: If the owners have decided to maintain an average amount of risk and the production manager has decided to use a lot of labor (and little machinery) to produce the product, then the financial manager has the flexibility to finance the company with a high degree of financial leverage. The high leverage (financial) offsets the low leverage (operating) yielding an average degree of total leverage (that satisfies the owners). That is,

Given that: Total leverage = Operating leverage * Financial leverage Average risk (set by owners) = Low risk (production manager) * High risk (financial manager) Desired leverage level is: Average total leverage = Low operating leverage * High financial leverage

A Useful Way to Picture a Company Although the following is not technically correct, I've found it useful to think of a company as being made up of two "black boxes." Divide the company up into (1) operating managers and (2) financial managers. Operating managers work in departments such as production, marketing, purchasing, shipping, etc. Their job is to produce and sell the company's products (and/or services). The financial managers have backgrounds in finance and accounting. Their major responsibilities are to manage the company's cash flow, arrange for suitable financing, and to minimize the taxes paid through sound tax planning. As a result of their efforts, the operating managers generate cash that flows into the company in the form of sales. They subtract the expenses generated by their departments (i.e., operating expenses) and what is left is EBIT, or net operating income. In essence, the operating managers are telling the financial managers, "Here is the profit that we have earned for the company. We're now turning it over to you. Try to keep as much of it as you can for the owners by minimizing the financial costs (i.e., cost of capital) and the taxes that have to be paid." The financial managers then try to exercise sound management techniques to minimize the financing costs and taxes. They subtract the expenses of their departments, and then turn over the remainder, or earnings after taxes, to the shareholders.

If you picture a company in this way, it's easy to visualize the operating and financial leverage of a company. Operating leverage deals with the relationship of EBIT to Sales, the two items on either side of the operating "box." More exactly, Operating leverage is the percentage change in EBIT divided by the percentage change in Sales.

Financial leverage deals with the relationship of Earnings After Taxes to EBIT, the two items on either side of the financial "box." More exactly, Financial leverage is the percentage change in EAT divided by the percentage change in EBIT. The degree of magnification of income is determined by the level of fixed costs within the boxes. If there is a high level of fixed cost within either box, the output of that box may be several times the input of that box (in percentage terms). For example, a 1% change in sales may lead to a 3% change in EBIT (a magnification of 3x caused by the fixed operating expenses). That 3% change in EBIT may lead to a 6% change in EAT (a magnification of 2x caused by the fixed financial expenses). Notice that, in this example, the Total Leverage will be 6x, i.e., the percentage change in EAT will be 6 times the percentage change in Sales.