Degree of Financial Leverage

It assesses sensitivity of net income when capital structure changes

The degree of financial Leverage (DFL) assesses how sensitive a company's net income is to changes in its capital structure

How much debt a corporation can responsibly take on depends largely on its level of leverage. In this post, we go through the definition, significance, and two methods for calculating the degree of financial leverage.

The DFL is a percentage that financial experts use to show changes in a company's net income due to changes in its profits before interest and taxes (EBIT).

The DFL ratio can reveal a company's DFL, which impacts how volatile its earnings are. Businesses assess their long-term success and financial health using the degree of the financial leverage ratio.

The level of leverage is an important statistic for determining how operational costs, obligations, and expenses affect revenue and profits.

Financial analysts and accountants can use this ratio to analyze the erratic variations in earnings and identify areas where corporations could streamline their operations to pay off debts, reduce costs, and pay less in mandatory corporate taxes.

A company can use the DFL to assist evaluate how much debt it can take on and still turn a profit. For example, a corporation can take on more debt when its operating income is stable, which also means that its EPS and total earnings are stable.

Let us take an overview.

Financial Leverage

The ratio of a company's equity to financial debt is known as financial leverage. It is a crucial component of a company's financial strategy. Another definition of financial leverage is utilizing corporate financial resources at a set cost.

Financial leverage of two means two dollars of debt for every dollar of equity (D/E). This enables the business to finance asset acquisitions with debt.

When a corporation is unable to raise its operating efficiency and returns on total investment, it is typically utilized to increase returns on equity capital.

The following advantages of leverage are offered to businesses:

  • Using leverage is a crucial tool for management to employ when choosing the best financing and investment options for a company.
  • It offers a range of funding options the company can use to fulfill its capital expenditure and working capital needs.
  • Leverage is another crucial investing strategy since it aids businesses in establishing a ceiling for the growth of their operations. When the predicted return on extra investment is less than the cost of debt, it might be used, for instance, to urge limitations on business expansion.

How to Calculate Leverage's Effect

When a business borrows money and uses it for its industrial and commercial activities, it creates operating profits that often outweigh the interest payments on its debt.

The economic profit is the difference between the returns on capital employed (ROCE) and the weighted average cost of capital (WACC). It shows the excess profits earned over and above the cost of financing.

Also, at times referred to as supernormal profits, it is a very positive sign for a company. Debt is cheaper than equity capital, helping the management reduce the overall cost of capital and maximizing economic profits.

Market

The leverage effect of debt also increases the return on equity.

When the leverage is used to its fullest potential, a company's return on equity increases since increased stock volatility and risk lead to higher returns. Conversely, companies with excessive financial leverage can see their return on equity decline.

  • Due to this, the impact of increasing debt on common stockholders' earnings per share is used to calculate financial leverage.
  • Leverage is crucial in assisting in meeting investors' expectations for return on equity since shareholders' return on equity of capital is typically higher than the economic return ratio.

Advantages and disadvantages

Leverage, like any other financial tool, has benefits and drawbacks that you should be aware of before using it for your personal or professional interests.

Leverage can increase both gains and losses when utilized by a business or an individual investor because it is a versatile financial tool.

Thus, being aware of its benefits and drawbacks will help you grow your company and determine whether it is ready to employ this financial tool just yet.

Advantages 

1. Companies or individuals who use leveraged investments to borrow loans can invest a small amount of money.

2. These organizations and corporations can acquire more assets and resources for their organization through this leveraged investment.

3. Assume that the situation is favorable and the asset value rises. In that situation, it is highly advantageous to the borrowers as they can increase the returns on their investments, enabling them to maintain the profit margin.

Disadvantages

A few of the disadvantages are:

  1. The only risk when utilizing leverage is the loss that the firms might experience if the asset value decreases and goes below the interest that the companies must pay on their obligations.
  2. Construction, oil production, and automobile manufacturing are a few industries where this financial risk is particularly significant because these industries stand to lose the most money if asset values decline.
    • This is the case because their type of operating profits or cash flow is based on real assets; they have nothing more and nothing less.
  3. Leverage investments can devastate firms and even lead to their closure if they are not used properly. Businesses that generate less stable revenue and are less profitable are particularly affected.
  4. This is another reason why many novice investors are discouraged from utilizing leverage until they know how to prevent such a significant loss to their business.

The risk associated with leverage 

The risk may be influenced by the unpredictable value changes of collateral assets. For example, brokers could want more money if the value of the securities being held drops. This is what is known as 'Margin Call.'

When the value of the real estate falls below the debt's principal, banks may decide not to renew mortgages. Loans may be called in even if cash flow and profits are enough to maintain the ongoing borrowing expenses.

This may occur exactly at the moment when there is low market liquidity or a lack of buyers, and other people's sales are driving down prices. 

The main risk associated with high leverage happens when a company's return on assets (ROA) does not surpass the loan's interest rate, significantly reducing its return on equity and profitability.

This indicates that leverage increases relative to the updated equity value as market prices decline, increasing losses as prices decline further.

This can quickly bring about catastrophe because even if the underlying asset value loss is slight or brief, the loan financing may only be temporary and hence be needed for repayment immediately.

Negotiating the conditions of leverage, keeping unused capacity for additional borrowing, and leveraging only liquid assets that can be quickly converted to cash can all help to reduce risk.

Leverage Vs. Margin

After thoroughly discussing leverage, let's now address the widespread misunderstanding that most people have regarding leverage and margin. Unfortunately, these two concepts are frequently confused.

The two terms are not interchangeable even though they are connected, and both involve borrowing.

Leverage is the debt calculation utilized to generate higher returns and account for equity for your business or corporation. Meanwhile, margin refers to the amount of money needed to start a position that depends on the margin rate.

Margin is another type of leverage that includes utilizing the company's current cash or security holdings as collateral to improve its purchasing power.

Thus, the margin enables you to borrow money at a predetermined interest rate from a lender to buy positions, stocks, futures & options contracts to trade, hedge, etc.

This indicates that even while margin and leverage aren't the same, margin can be used to produce leverage to boost your buying power somewhat.

formulas

The level of leverage is an important statistic for determining how operational costs, obligations, and expenses affect revenue and profits.

DFL = (% of change in net income) / (% of change in the EBIT)

a) Calculate the Net Income

NI = (Revenue) - (COGS) - (expenses)

b) Calculate the Net Income change as a percent

To find the DFL, you must know the percentage change in net income. This percentage can be calculated using the formula below:

% Of Change in NI= [(current NI) - (Previous NI)] / (Previous NI) x 100 

c) Calculate your Earnings Before Taxes and Interest (EBIT)

As this value indicates a company's operating earnings before it pays its taxes and any interest that may have accrued on debt, the EBIT is the net income plus interest and taxes.

You must be aware of your EBIT for current and prior periods to calculate the percent change in EBIT.

  EBIT= (net income) + (interest) + (tax)

Agreement

d) Determine the percentage shift in your EBIT

Use the following formula to determine the percent change in EBIT after calculating EBIT:

% Of change in EBIT = (current EBIT - previous EBIT) / (previous EBIT) x 100

e) Calculate the Degree of Financial Leverage

Divide these two numbers to obtain the DFL after determining the percent changes in net income and EBIT.

DFL = (% of change in NI) / (% of change in the EBIT)

Example

1. % change in NI= 8.7%

% Of change in EBIT = (current EBIT - previous EBIT) / (previous EBIT) x 100

2. % change in EBIT= 2.95%

% Of change in net income = [(current net income) - (previous net income)] / (previous net income) x 100

DFL = (8.7%) / (2.95%) = 2.95%

Analyzing the DFL

The amount of debt your company or organization can manage and repay will be determined once you have established the level of financial leverage. 

The volatility of earnings increases with the percentage of DFL. If a corporation takes on too much additional debt and interest, it may suffer, according to a high DFL value.

The example business can rationally incur additional interest on debts because its DFL shows little change in income and earnings.

Since interest is a fixed item, the DFL can be used to determine how much interest on debt a corporation can afford to pay over the long run.

This is advantageous when operating income increases, but it may present difficulties when operating income is constrained.

Understanding the Financial Leverage  

The simplest way to comprehend the concept of leverage is through your home mortgage. Leverage generally works in the homeowner's favor most of the time. However, financial leverage must fulfill two crucial conditions for it to be useful.

To prevent repossession, the borrower must first be able to make payments. Second, the value of the underlying asset affects the leverage.

Leverage increases the potential profit on the asset if it increases in value, but it decreases returns on investment if it decreases in value.

In the absence of these two requirements, leverage becomes unfavorable.

Leverage is risky since most people have emotional confidence about its ability to increase earnings without considering the potential obligations they may have to pay back if the plan doesn't work out.

New companies either launch quickly and lose their momentum when a rival firm takes customers' attention away from them, or they start slowly and establish a reputation as more people learn about their best service offerings.

However, borrowing drives up the company's fixed costs. Therefore, the effectiveness of borrowed money depends on your ability to avoid potential problems.

Did you know?

When investors and low-interest rates encouraged the management of various companies to take on more debt than they could handle to finance growth and acquisitions, this was an example of leverage being used in the late 1980s.

When they were unable to pay back loans, many of these businesses-including Orion Pictures, Live EntertainmentCarolcoNew World Pictures, and Cannon Group-were forced to declare bankruptcy.

Most of these businesses, many of which are from Hollywood, neglected to remember that they still had to pay back their loans even if the projects they used the funds to finance were unsuccessful.

To effectively use leverage, a business must make cautious management decisions, use common sense, and objectively evaluate risks!

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Researched and authored by Charbel YammineLinkedIn

Reviewed and edited by Aditya Salunke I LinkedIn

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