Firms employ external funds to finance business operations. External funds differ by the required or expected return that investors need, when (or if) the funds need to be paid back and the order in which they are paid back.
Leverage is the utilization of assets or funds, for which the firm has to pay a fixed charge or fixed return.
To start our latest business venture, we need 1,000 dollars. We can borrow 500 dollars from friends and invest 500 dollars from our own account. The friends 500 dollars need to be paid back in two years and we need to pay them 50 dollars a year for lending the money.
When it comes to using the 1,000 dollars, we have two choices. We can go the local hardware store and buy a new laptop for our business for 800 dollars or we can lease it from the same store for 20 dollars a month. The second option is very attractive since it leaves the bulk of the 1,000 dollars for later use. The business still owes 800 dollars to the store, but that obligation can now be settled over a three-year period.
Using leverage we did two things that would not be possible by using just our limited resources. We doubled the amount available for use by the business and then by adding additional leverage made the amount last significantly longer.
Why is leverage important?
First, the level of debt determines the interest expense a business has to bear before it can pass on its earnings to shareholders. Interest expense is also a fixed cost and a business has to make interest payments irrespective of the level of production or profits.
Second, leverage increases the upside as well as the downside for a business. In profitable situations, leverage boosts the Return on Equity and in non-profitable situations it decreases the Return on Equity. Higher leverage leads to higher risk as well as higher return in good times. But in bad times, higher leverage leads to bigger dents in profitability and Return on Equity.
Ultimately, there is a trade off between the beneficial impact of leverage (the ability to earn more returns) and the risk enhancing effect of leverage (the impact on fixed costs due to interest payments). Businesses fail miserably when they misread this trade off.
Leverage and Fixed and Variable Costs
Costs incurred by a firm can be divided into fixed and variable components.
Fixed costs are those that will occur irrespective of the level or volume of production (units produced). A firm will incur fixed costs even if nothing is produced. For example, if you have leased equipment for production, you will have to pay these lease payments irrespective of whether you produce or not.
Variable costs are those that are not incurred if no production takes place. They only occur when production begins; these costs vary with the level of production. For example, direct labor costs and raw material costs depend on the level of production.
The relationship between fixed costs, variable costs and the level of production is the Cost Function. Cost functions may be linear (directly proportional to the level of production) or non-linear (costs may increase more than the unit increase in production or vice versa).
Relevant range of production
Relevant range of production is a given range within which the business can operate without needing to change its cost function and more importantly, its fixed costs.
For example, Firm A can produce between 25,000 to 50,000 tennis balls per month given the current plant capacity. Fixed costs for producing anything between 25,000 and 50,000 are $ 90,000 per month. If a firm decides to produce more than 50,000 balls, it will have to install additional plant equipment as well as upgrade related facilities, which means that it will incur additional fixed costs. Therefore, in the example above, the ‘relevant range of production’ is 25,000 to 50,000 tennis-balls.
Fixed and variable costs and their impact on leverage
Leverage relates directly to sources of funds (or assets) that have a fixed cost associated with use. We focus on two different types of fixed costs
- Fixed expenses or costs that a firm incurs, which have an effect on the operations of a firm. For example, a business has to incur maintenance expenses to keep a plant operational or pay salaries or rent to keep the office open. These costs will be incurred irrespective of level of operations or production.
- Fixed charges that result from taking on debt. Top of the list are interest expenses & lease payments. Once again, it doesn’t matter if anything was produced or not, these payments would still need to be made.
Fixed costs, financial or operational, increase the risk of a business. When a revenue downturn occurs, variable cost – cost directly related to revenues, also reduce proportional (the reason why they are variable costs). Fixed costs, however, remain at the same level. For a healthy business this may mean a big profitability problem or a switch from generating cash to consuming cash. If the revenue downturn is temporary, and adequate reserves exist, most businesses survive. For not-healthy businesses, the picture is not so pretty. A reduction in revenues may lead to change in control (management), credit downgrades, financing problems and even bankruptcy.
Operational and financial leverage help us understand how a business uses leverage. The key theme in both categories is commitment to fixed charges. Managers as well as investors need to understand these concepts to manage the downside risk of a business or investment.
Both these concepts use numerical data from the income statement. Remember, that most of the expenses shown in the income statement can be classified as being either fixed or variable. For a discussion on operating and financial leverage it is important to understand what fixed and variable costs are and how they interact to affect the operations of a firm.