The use of fixed charges (or interest) bearing sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure of a company is described as financial leverage or gearing or trading on equity.
The use of fixed charges (or
interest) bearing sources of funds, such as debt and preference capital along
with the owners’ equity in the capital structure of a company is described as
financial leverage or gearing or trading on equity.
The use of term trading on equity
is derived from the fact that the debt is raised on the basis of the owner’s
equity - the equity is traded upon. Since the debt provider has limited
participation in the company’s profits he will insist on to protect his
earnings and protect values represented by ownership equity.
Financial leverage is the name
given to the impact on returns of a change in the extent to which the firm’s
assets are financed with borrowed money. The financial leverage is employed by
a company only when it is confident of earning more return on fixed charge
funds than their costs. In case the company earns more than the derived surplus
will increase the return on the owner’s equity. In case the company earns less
on the fixed charge funds when compared to their costs, the resultant deficit
will decrease the return on owner’s equity. The rate of return on the owner’s
equity is thus levered above or below the rate of return on total assets.
Thus a simple logic can be
arrived at as under. If all other things remain same, lower the amount borrowed,
lower the interest, lower will be the profit and greater the amount borrowed,
lower the interest, greater will be the profit
Financial leverage reflects the
amount of debt used in the capital structure of the firm. Because debt carries
a fixed obligation of interest payments, we have the opportunity to greatly
magnify our results at various levels of operations. The degree of financial
leverage is computed as the percentage change in earnings available to common
stockholders associated with a given percentage change in earnings before
interest and taxes.
Thus financial leverage is a
commitment to fixed debt charges payment obligation undertaken by a company.
of financial leverage
Debt ratio is the ratio of debt to the total
available funds of the company, i.e.
sum of owner’s equity and outside debt. The owner’s equity can be measured in
terms of either book value or the market value. In some countries it is also
named as leverage ratio. It is defined down traditional lines as the ratio of
external debt to total equity
Debt equity ratio is the ratio of debt to the total
equity. Here too, the equity can be
measured in terms of either book value or the market value
The market value of equity in
debt ratio and debt equity ratio is more appropriate, because market values
normally reflect the current attitude of the investors, in
If the shares of the company are
not traded in the stock exchanges (or markets) or are not actively traded in
the stock exchanges then it would be difficult to get correct information on
market values. The debt ratio and debt equity ratio are also known as capital
Interest coverage is the ratio of earnings before
interest and taxes (EBIT) to the
interest liability. This is known as coverage ratio i.e. debt coverage ratio or
debt service coverage ratio. The reciprocal of interest coverage that is
interest divided by EBIT is known as income gearing.
Degree of financial
The degree of financial leverage
(DFL) is defined as the percentage change in earnings per share [EPS] that
results from a given percentage change in earnings before interest and taxes
(EBIT), and it is calculated as follows:
DFL = Percentage change in EPS
divided by Percentage change in EBIT This calculation produces an
index number which if, for example, it is 1.43, this means that a 100 percent
increase in EBIT would result in a 143 percent increase in earnings per share.
(It makes no difference mathematically if return is calculated on a per share basis
or on total equity, as in the solution of the equation EPS cancels out.) When the economic conditions are
good and the company’s Earnings before interest and tax are increasing, its EPS
increases faster with debt in the capital structure. The degree of financial
leverage is expressed as the percentage change in EPS due to a given percentage
change in EBIT.DFL = %
change in EPS / % change in EBIT An alternate formula to calculate
the degree of financial leverage is as follows: DFL =
EBIT / (EBIT – Int) = EBIT/PBT = 1 + INT/PBT Financial leverage on the one
hand increases shareholders’ return and on the other, it also increases their
risk. For a given level of EBIT, EPS
varies more with more debt. Thus financial leverage is a
double edged weapon. It may assure you a higher return but with a higher risk.
Normally, a trade off between the return and risk will be arrived at to
determine the appropriate amount of debt. Let us
examine this with an example A company’s expected EBIT is
Rs.150 with a standard deviation of Rs.50. This implies that the earnings could
vary between Rs.100 and Rs.200 on an average. Suppose that the company has some
debt on which it incurs Rs.50 as interest. Now the shareholders’ expected earnings will be
Rs.150 less Rs.50 = Rs.100 (taxes are ignored). Standard deviation will remain
unchanged at Rs.50. Now the shareholders earnings will on an average vary
within a range of Rs.50 and Rs.150. If EBIT is Rs.50, then the shareholders may
not earn anything. If it is less than Rs.50, their earnings may be negative. In
extreme situations if the company is unable to pay interest and principal on
the debt borrowed, its very existence may be threatened by the insolvency
proceedings that may be initiated by the creditors.
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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