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Credit Analysis: Understanding Financial Leverage

Credit Analysis: Financial Leverage

What impact do fixed financial charges (financial leverage) have on a firm’s financial position?

Fixed operating costs make a firm’s Operating Income more sensitive to changes in Sales. The next step would be to see if the same relationship holds for fixed financial charges. That is, will a firm’s Net Income (NI) become more sensitive to changes in operating income when the firm is financially leveraged?

Leverage Fixed Costs and Income

Impact of leverage and fixed cost on income

Long-term debt carries a fixed cost – interest payments that need to be made. The payments may be variable (flexible / variable rate debt), but they are still independent of revenues or level of sales. Interest expenses appear in the second half of the income statement. We need to know whether the second half of the income statement shows sensitivity to changes in net income due to the presence of these fixed financial charges.

The second half of the Income Statement of Waterloo Inc. for 1999 is given below:

Income Statement1999
Operating income$210,000
Less: Interest expense($112,000)
Net profits before taxes$98,000
Less: Taxes (40%)($39,200)
Net Income$58,000

We can see that the interest expense in 1999 was $112,000. Let’s assume that the interest due was on a mortgage loan that was used to purchase a new warehouse. The mortgage was for $800,000 and interest was payable at the rate of 14% per annum.

What if management decided to buy the warehouse and asked the original investors to invest another $800,000 in the business.? In this case interest expense would have been zero, and the income statement would have looked something like this:

Income Statement1999
Operating income$210,000
Less: Interest expense0
Net profits before taxes$210,000
Less: Taxes (40%)($84,000)
Net Income$126,000

Net Income is higher. If profitability is higher in the absence of leverage, why do firms take on leverage? Most managers face the same question each day. A new plant has to be installed; should the money be generated internally, through equity or through a loan? The plant will cost a $1,000,000. Should the entire amount be financed through debt or equity or will a combination of debt or equity be better? What if 40% of the $1,000,000 is generated through debt? What if its 60%?

These are realistic questions that any manager needs to answer before making a financial decision. A deeper analysis of leverage will help us understand some of the issues involved in answering these questions.

Before anyone outside a business provides financing, he or she will always look at how much money the original owners have invested. This helps assess the cushioning or margin of safety that exists for them; the lower the investment by owners, the higher the risk for creditors. On the other hand for owners if a firm generates funds through external financing, stockholders can still maintain their control on the business with a limited investment.

The key to leverage is increasing returns. If by putting additional capital to work (especially borrowed capital), you can still earn more than the cost of capital, you can create value for original owners and magnify their return on investment. However, there is always a caveat. When the firm does not earn the cost of borrowed funds, return on owners’ capital takes a hit. As a firm’s ratio of debt to equity increases, financial leverage increases and Net Income becomes increasingly sensitive to changes in Operating Income. If the firm goes through a tight spot, the decline in earnings is also magnified. This concept is demonstrated with the help of examples later in the session.

Degree of Financial Leverage

Degree of Financial Leverage is a numerical measure that assesses the magnification in Net Income due to changes in Operating Income, when a firm is financially leveraged. The measure is calculated using book value information and hence represents the internal situation of the firm and not market sentiments. Let’s run through the concept with the help of an example.

Shine Inc., a light-bulb manufacturer, decides to install a new plant. You are the plant manager with two alternatives and have been asked to make a decision as to how the plant should be financed and why:

  1. The plan can be financed through equity only or
  2. The plant can be financed through a mixture of equity and debt.

If you believe that the second alternative is viable, then in what proportion should debt and equity financing be used? The new plant costs a $1,000,000. The Cost of Debt, if external financing is used, is 15%. To keep things simple and focused on DFL, we will assume there are no state or federal taxes paid or owed by the business.

The Income Statement for 1999 under Option A, that is if equity financing is the sole method of financing, is given below:

Option A

Income Statement1999
Sales$4,000,000
Less: Total Operating costs($3,120,000)
Operating income$880,000
Less: Interest expense0
Net Income$880,000

Let’s take a look at Option B and use 40% debt and 60% equity as a starting point. The Income Statement of Shine Inc. would look something like this:

Option B

Income Statement1999
Sales$4,000,000
Less: Total Operating costs($3,120,000)
Operating income$880,000
Less: Interest expense$60,000
Net Income$820,000

We see that with the use of debt financing Net Income has gone down. The only reason is the interest payment of 15%The Degree of Financial Leverage (DFL) can be calculated by one of the following two formulae:

Formula 1

DFL =    % Change in Operating Income / % Change in Net Income

Formula 2

With the help of Formula 1, it is very easy to develop formula two. We can simply take the absolute values of Operating Income and Net Income.

The numerator of the equation consists of the operating income, which can be calculated by the following formula:

Operating Income = Units Sold * (Selling Price per Unit – Variable Cost per Unit) – Fixed Cost

The denominator in the equation is the Net Income, which can be computed as follows:

Net Income = Units Sold * (Selling Price per Unit – Variable Cost per Unit) – Fixed Cost – Interest

DFL can be calculated by dividing the Operating Income by the Net Income, as follows:
DFL = Operating Income / Net Income

DFL =  [Units Sold (Selling Price per Unit – Variable Cost per Unit) – Fixed Cost]
[Units Sold (Selling Price per Unit – Variable Cost per Unit) – Fixed Cost – Interest]

The first formula is used to compare the DFL between two years and / or between two alternative situations. It becomes a valuable indicator of where the firm is heading. The second formula is normally used when only one accounting period is considered and when comparisons are not being made.

Using the first formula we’ll calculate the DFL for both the financing situations A and B.

Shine Inc.Option AOption B
Operating Income880,000880,000
Net Income880,000820,000
DFL11.07

We have seen from the above example that as the proportion of debt increases, financial leverage also increases – DFL has increased from 1 to 1.07. This shows that with the acquisition of additional debt a firm’s Net Income becomes more sensitive to changes in a firm’s operating income.

With only equity financing, the change in Net Income was the same as the change in Operating Income, which is why DFL is 1. However, with increase in leverage, NI has become more sensitive to changes in operating income. For every dollar change in Operating Income, NI changes by $1.07.

Let’s say that you would like to try out Option C, using 60% debt financing and 40% equity. Hence, of the $1,000,000, $600,000 would be generated through external financing. The Income statement would look something like this:

Option C

Income Statement1999
Sales$4,000,000
Less: Total Operating costs($3,120,000)
Operating income$880,000
Less: Interest expense$90,000
Net Income$790,000

The DFL will be as follows:

Shine IncOption C
Operating income$880,000
Net Income$790,000
DFL1.11

DFL is now at 1.11. It should be noted here, that an increase in debt from zero to 40% results in a change in Net Income of $1.07 for every dollar of change in Operating Income. As debt financing increases to 60%, a change of $1 in Operating Income leads to a change of $1.11 in Net Income.

Shine Inc.Option AOption BOption C
Operating Income880,000880,000880,000
Net Income880,000820,000790,000
DFL11.071.11

A word of caution! This increase in sensitivity exposes the business to a higher levels of risk, especially during slow downs. The fluctuations in NI in due to Operating Income apply both ways – when operating income is rising and when it is falling. Look at Option B: a fall in the operating income of $1 will also lead to a fall in the NI of $ 1.07. In Option C, the fall will be $1.11 for a dollar fall in operating income.

The downside of Financial Leverage

Financial leverage makes a firm more risky for investors. Let’s take the case of Scrooge Inc. and see what happens to the NI of the business during good and bad times, when it is leveraged and when it is not. Let’s assume that the company is just being set up and management needs to decide whether or not debt should be used to finance assets and in what proportions.

As a key manager, have been asked evaluate what will happen to the firm’s income in two alternative situations:

  1. When sales amount to $200. (This level of sales will be achieved in economic booms.)
  2. When sales amount to $160. (This level of sales will be sustainable during slow downs.)

To support this level of sales you need an asset base of 200 dollars. You have two alternatives. You can either finance all your assets through equity or you can use 50% debt financing. You need to decide between these two alternatives based on what your expectations are for the future. The state of the economy, expected demand conditions, the intensity of competition and internal factors will determine the final call.

What happens when Scrooge Inc is not leveraged? The Balance Sheet is given below:

Balance Sheet
Current Assets100Debt0
Fixed Assets100Equity200
200200

Under this alternative, you want to use $200 worth of equity to finance $200 worth of assets. According to your estimates, the income statement of Scrooge in good and bad times is expected to be as follows:

Income StatementGood ConditionsBad Conditions
Sales$200$160
Operating Costs140150
Operating Income6010
Interest00
Earnings before taxes6010
Taxes (40%)244
Net Income366
ROE18%3%

ROE is expected to be 18% if all goes well, and only 3% when things turn sour.

Let’s see what would happen if you use 50% debt financing (that is, you want to use $100 of debt and $100 of equity to finance your assets). The Balance Sheet of the firm, under this condition, would be as follows:

Balance Sheet
Current Assets100Debt (Interest 15%)100
Fixed Assets100Equity100
200200

 

You expect the Income Statement to be as follows:

Income StatementGood ConditionsBad Conditions
Sales$200$160
Operating Costs140150
Operating Income6010
Interest1515
Earnings before taxes45-5
Taxes (40%)180
Net Income27-5
ROE27%-5%

Leverage, and associated interest charges, place a heavy burden on a firm’s earnings if an economy goes into recession, or if a firm experiences a decline in sales (either due to competition or because of an outdated product). Since NI is more sensitive to changes in Operating Income if a business is highly leveraged, the firm is worse off when it hits a bad spot.

Your final decision in the example given above depends a great deal on the risk profile of your company and the attitude of the management towards leverage and risk. If you hold a crystal ball that tells you that good times are there forever, you will probably use the highest level of debt financing available. Without the crystal ball, you would be taking a big bet, especially if you operate in a volatile and uncertain environment.

In the North American market today, there are various industries that use leverage extensively. The banking industry is an ideal example. But bank valuations are the first to take a hit when a slow down is predicted.

Why do businesses, like banks, become leveraged (and, therefore, risky)? The objective of a business is to create value for its owners and generate a fair return on invested capital. Return on Equity or ROE is a measure of the return that a business generates for owners. If a business is financed through equity only, Return on Equity is the same as the Return on Assets. The existence of leverage in the financial structure enhances Return on Equity.

Bank One Corporation is a great example. Bank One Corporation is the fifth-largest bank holding company in the U.S. with $280 billion dollars in assets. The firm targets large corporate and middle market commercial customers and retail consumers. It offers a full range of financial services including credit cards, ATMs, loans, mutual funds management, investment management and all other commercial services.

The company’s shares are traded on the NYSE under the symbol ONE. Its market capitalization was $45.3 billion as of February 1, 2001.

The NI of the firm in 1999 was $3.48 million. Total Assets during the same year amounted to $269.4 billion. Let’s assume for a minute that all assets were financed only through equity. The Return on Assets (ROA) and Return on Equity (ROE) would be the same (1.3%). Now let’s take the actual situation where $249.4 billion or nearly 93% of the assets have been financed through debt.

Before we do a detailed analysis of Bank One, lets introduce a tool first. The overall profitability of a firm depends on the entire operations of the firm. Operations and their results can be assessed from the profit margins, leverage and turnover of the business. A common way of evaluating the Return on Equity is by breaking down the equation into its components.

ROE = Net Income / Equity

The above equation can be further broken down into its components in the following manner:

ROE    = (Profit Margin) * (Asset Turnover) * (Equity Multiplier)

= (Net Profit / Sales) * (Sales / Total Assets) * (Total Assets / Equity)

= (Net Profit / Sales) * (Sales / Total Assets) * ([Liabilities + Equity] / Equity)

We can see above that a firm’s ROE is a function of three components:

  1. Asset Turnover
  2. Equity (and/or leverage, that is whether assets are financed by equity or debt, and in what proportions)
  3. Profits or profitability of products being sold.

Management can increase or jack up ROE by increasing by playing with these three components.

Let’s get back to Bank One. We have seen that 92.5% of assets were financed through debt in 1999. One beneficial effect of this is now apparent. The bank’s Net Profit was 0.2 or 20% of sales in 1999. Asset Turnover was 0.064 or 6.4% in 1999, while the Equity Multiplier was 1341. If liabilities are high or are increased, the numerator in the last component increases, which causes the entire ROE to rise. This is shown as the effect of the equity multiplier.

Hence, the Return on Equity for Bank One is:

ROE    = (0.2) (0.064) (1341)

= 17.1%

If the equity multiplier had been lower (due to a low level of leverage), ROE would have been much lower. One big reason why firms use high amounts of leverage is to jack up ROEs. Taxes and ownership and control issues are other reasons. They have been discussed in earlier sessions on leverage.

Combining Financial and Operating Leverage

The impact of combined leverage.

Operating leverage is magnification that takes place in a change in Operating Income (EBIT) for a given change in sales. This effect takes place due to the presence of fixed operating costs. Financial leverage is the magnification that takes place in the change in Net Income for a given change in Operating Income. This effect is because of fixed financial charges that result from leverage.

Both these measures are closely related to fixed costs (operational and financial) of a business. So, if they are combined, the total risk associated with leverage can be determined. In other words, the overall impact of a change in NI resulting from a change in sales can be gauged, by combining the two measures.

Hence,

Degree of Combined Leverage (DCL )= Degree of Operating Leverage (DOL) Degree of Financial Leverage (DFL)

Take Progressive Inc. we have already calculated the DOL and DFL of the firm, and they are:

Progressive Inc.
DOL6
DFL2.5

The Degree of Combined Leverage would be:

Progressive Inc.
DOL6
DFL2.5
DCL (DOL*DFL)15

We can deduce that a one dollar change in sales for Progressive would lead to a $15 change in Net Income. This magnification is the result of the combined effect of DOL and DFL (total leverage).

DCL is a very useful concept when it comes to financing decisions. Besides indicating the effect of change in sales on Net Income, it is also useful in deciding between alternative methods of financing for new projects. DCL also allows a firm to determine the right balance between operational and financial leverage. For example a reduction in operating fixed costs can reduce operating leverage and permit a firm to raise financial leverage by undertaking additional debt. At the same time the magnifying effects on NI can be kept constant.

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