A STUDY ON FINANCIAL LEVERAGE

An Innovative assignment submitted to

SRM Institute of science and Technology

In partial fulfilment of the requirements for the award of the degree of

MASTER OF BUSINESS ADMINISTRATION

Submitted by
ROHITH SV
(RA2352001020094)
M.B.A. FIRST YEAR ‘B’ SECTION

Under the Supervision of

Dr. S. LAKSHMI
Assistant Professor

FACULTY OF MANAGEMENT
SRM INSTITUTE OF SCIENCE AND TECHNOLOGY
RAMAPURAM, CHENNAI - 600 089
APRIL 2024

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 FINANCIAL LEVERAGE

What Is Financial Leverage?

Financial leverage is a process where businesses or individuals use loans to fund projects
or acquire extra assets for the business. After the project or asset acquisition is complete, the
borrower pays back the principal sum with the interest amount. The purpose of implementing
financial leverage is different for different entities. In various scenarios, the debt provider
puts a limit on the risk it is ready to take, indicating a specific limit on the leverage that
would be allowed.

What is Leverage in Financial Management?

Leverage in financial management is a type of investment where money borrowed is
used to get maximum return on investment or acquire additional assets for business
expansion. Businesses create such debts by borrowing capital from different lenders and
promising them to pay with additional interest after a specific time.

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In the financial management process of a company, the use of leverage acts as the reason to
increase asset values, increase the shareholders' value and acquire new equipment.
Nonetheless, individuals not wanting to get themselves involved in leveraging can invest in a
business that uses leverage methods to complete organisational activities. Asset value and
loan interest are the two main factors considered in this aspect.

Significance of Financial Leverage

The aspect of financial leverage is significant since it empowers both individual investors
and organisations to tap into investment opportunities that may surpass their existing cash
reserves. Although this strategy entails a level of risk, it has the potential to foster business
expansion, thereby generating additional employment opportunities and stimulating
economic activity.

Furthermore, it can enable nonprofit institutions such as hospitals and universities, which
frequently contend with limited regular cash flow, to expand their operations and extend their
reach to a larger audience.

Types of Leverage In Financial Management

There are three main types of leverage used in the financial management process of an
organisation. They are discussed as follows.

• Financial Leverage
This is the total debt a business acquires to fulfil different financial purposes. In the financial
statements, this type of spoof leverage is represented under the list of liabilities. Financial
leverage helps you to continue with your investments even if the business does not have
enough cash. Equity financing is the most preferred option in this case, as it allows you to
raise money without liquidating your ownership.

• Operating Leverage
Operating leverage pertains to the combination of fixed and variable costs associated with
delivering products and services. Fixed costs remain consistent, independent of output levels,
necessitating payment whether a business is profitable or incurring losses. The assessment of
operating leverage involves calculating the ratio between fixed and variable costs. If fixed

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expenses outweigh variable ones, a business exhibits high operating leverage. While this can
enhance returns, excessive reliance on it escalates financial risk.

• Combined Leverage
This type of financial leverage accounts for the total risk of your business. Such leverage
aggregates the effects of financial and operating leverage and presents a complete report of
your business's financial position. Moreover, this leverage is generally used by
capitalintensive companies that have the potential to expand but have low equity. Before
applying combined leverage, always remember to study the market conditions and be sure of
the future expenses of the business to avoid unnecessary risks.

Financial Leverage Ratio Formula

You can use many financial ratios to calculate your business's financial leverage. The
common financial leverage ratios and formulas that you can implement are discussed below.

Debt to Equity Ratio

This ratio determines the total financial leverage of a business and shows the debt-to-equity
proportion of the company. The result of this ratio helps the lenders, shareholders and
management of the company to understand the risk level in the capital structure of the firm.
The debt-to-equity ratio is calculated using this formula -
Debt to Equity (D/E) Ratio = Total Debt ÷ Total Equity

Debt to Capital Ratio

Debt to Capital ratio measures the financial leverage of a firm by comparing the debt of the
business to its capital. Here, debts can be both short-term and long-term, and capital is the
value of the total equity associated with debt and shareholders. The formula is -

Debt to Capital Ratio = Debt ÷ (Debt + Shareholder’s Equity)

Interest Coverage Ratio

This financial leverage ratio adds context to the liabilities of the business by providing data to
the analysts on how well the business can service the existing debts. Companies generally try
to keep this ratio 3 or higher, but it depends on the industry as well. The formula of this ratio
is -

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Interest Coverage Ratio = Operating Income ÷ Interest Expenses

Debt to EBITDA Ratio

With this ratio, the analysis of how well the business can pay off its debts and how likely it
can default in payment is assessed. EBITDA is earnings before interest, tax, depreciation and
amortisation. You can calculate this ratio using the following formula -

Debt to EBITDA Ratio = Debt ÷ EBITDA

Total Debt to Total Asset Ratio

As per this financial leverage ratio, you can understand the degree to which the assets of the

business are funded by taking debts. The formula is - Total Debt to Total Assets Ratio =

Total Debts ÷ Total Assets

Equity Multiplier

The calculation of this ratio helps stakeholders of a firm understand the weightage of
ownership in the business by analysing the way of financing assets. For a low equity
multiplier, the business is considered to be financed largely with equity and is not considered
a highly leveraged business. You can use this formula for calculation-

Equity Multiplier = Total Assets ÷ Total Equity

Degree of Financial Leverage

The degree of financial leverage or DFL is a financial leverage ratio that measures earnings
per share or EPS of a business with fluctuation in operating income due to the change in
capital structure. This ratio mainly denotes that higher financial leverage means the earnings
will be volatile.

The value of DFL is important to assess the valuation of financial leverage and determine

how businesses can streamline processes to reduce monetary obligations. However, if the

firm operates in such a sector where operating income is volatile, it is always recommended

to limit debts to a manageable and easy level. The formula used to calculate this ratio is -

DFL = % change in EPS ÷ change in EBIT

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Or,

DFL = EBIT ÷ (EBIT - Interest)

*EBIT means Earnings Before Interest and Tax Financial

Leverage Example

Here is an example that will help you understand how financial leverage works.

Suppose Company XYZ wants to acquire a valuable asset worth Rs. 10,00,000. Now, the
company faces a choice between two methods of financing: equity or debt.

If Company XYZ opts for the equity route, it means they are willing to give away a part of
their company to own the asset. In this case, they will fully own the asset from the beginning,
and there won't be any interest payments involved.

If the value of the asset appreciates by 40%, the asset's new value would be Rs. 14,00,000,
resulting in a profit of Rs. 4,00,000 for the company. Conversely, if the asset's value
depreciates by 40%, the asset would be worth Rs. 6,00,000, leading to a loss of Rs. 4,00,000
for the company.

Alternatively, Company XYZ could choose a different path by financing the asset using a
combination of common stock and debt in a 50/50 ratio. In this case, if the asset appreciates
by 40%, its value would also become Rs. 14,00,000. It can then use the profit to pay off the
debt faster and own the asset completely.

Limitations of Financial Leverage

There are a few limitations to using the financial leverage method in your business. They are:

• There is no guarantee of returns on investment. If anything goes haywire, you still

have to repay the amount you borrowed.

• If you default or fall behind in paying the loan or credit, it can damage your credit
capability among lenders.

• Borrowing money from relatives or family can strain personal relationships if things
in the business don't work out.

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 • If you borrow money against your personal asset, such as a house or car, there is a
risk you will lose it if you default.

Advantages of Financial Leverage

Even if the risks of financial leverage are high, there are some advantages to this method.
They are:

• If you borrow money, you can invest it in the business sooner or later.

• Investing the borrowed money can help in the growth of your business as well as your
wealth for a longer period

• Your investments also have the potential to improve your quality of life.

Example
Financial leverage refers to the use of debt to finance operations and investments, with the
aim of increasing the potential returns to shareholders. It magnifies the impact of changes in
operating income on net income and return on equity. Let's illustrate financial leverage with a
simple example:

Suppose Company A and Company B are two identical companies with $1 million in assets
each. Both companies generate $200,000 in operating income before interest and taxes
(EBIT). However, Company A decides to finance its operations with debt, while Company B
operates entirely with equity.

Company A:

Total Assets: $1,000,000

Debt: $500,000 Equity:

$500,000 Company B:

Total Assets: $1,000,000

Equity: $1,000,000
Now, let's calculate the net income for both companies under two scenarios: a favorable and
an unfavorable one.

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Scenario 1: Favorable Scenario (EBIT increases by 20%)

EBIT for both companies: $200,000 * 1.20 = $240,000 Company

A:

Interest Expense (assuming 5% interest rate on debt): $500,000 * 0.05 = $25,000

Earnings Before Taxes (EBT): $240,000 - $25,000 = $215,000 Net

Income (assuming 30% tax rate): $215,000 * 0.70 = $150,500

Company B:

Earnings Before Taxes (EBT): $240,000

Net Income (assuming 30% tax rate): $240,000 * 0.70 = $168,000

Scenario 2: Unfavorable Scenario (EBIT decreases by 20%)

EBIT for both companies: $200,000 * 0.80 = $160,000 Company

A:

Interest Expense: $25,000

Earnings Before Taxes (EBT): $160,000 - $25,000 = $135,000

Net Income: $135,000 * 0.70 = $94,500

Company B:

Earnings Before Taxes (EBT): $160,000 Net

Income: $160,000 * 0.70 = $112,000

Analysis:

In the favorable scenario, Company A's net income increased from $94,500 to $150,500, a
significant rise of 59.2%. This is due to the magnifying effect of debt on returns.
However, in the unfavorable scenario, Company A's net income decreased from $112,000 to
$94,500, a decline of 15.6%. Here, the use of debt amplifies the impact of the decrease in
EBIT, resulting in a greater reduction in net income compared to Company B.

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This example demonstrates how financial leverage can enhance returns in favorable
conditions but also increase risks and amplify losses in unfavorable conditions.

Conclusion

Introducing financial leverage in your business can help you grow your business and wealth
faster. The borrowed money can be utilised to invest in new projects, fund ongoing projects
or grow the capital structure of the firm, helping you get higher returns after a certain tenure.

However, before introducing this method in your firm, make sure to have a chat with
professionals about how effectively this method can be implemented in the business and how
you can grow your business without many risks.