(247)---MEASURES OF FINANCIAL LEVERAGE

Measures of Financial Leverage

The most commonly used measures of financial leverage are:

• Debt ratio.
  

The ration of debt to total capital

L1 = D / (D+E) = D/V

Where D is value of debt, E is value of shareholders’ equity and V is value of total capital. D and E may be measured in terms of book value. The book value of equity is called net worth. Shareholder’s equity may be measured in terms of market value.

• Debt-equity ratio
  

The ratio of debt to equity,

L2 = D/E

• Interest coverage
  

The ratio of net operating income to interest charges

L3 = EBIT/Interest

The first two measures of financial leverage can be expressed either in terms of book values or market values. The market value to financial leverage is theoretically more appropriate because market value reflects the current attitude of investors. But it is difficult to get reliable information on market values in practice. The market values of securities fluctuate quite frequently.

There is no difference between the first two measures of financial leverage in operational terms. They are related to each other in the following manner.

L1 = L2 / (1+L2) = (D/E) / (1+D)/E = D/V

L2 = L1 / (1-L1) = (D/V) / (1-D)/V = D/E


These relationships indicate that both these measures of financial leverage will rank companies in the same order. However, the first measure is more specific as its value will range between zeros to one. The value of the second measure may very from zero to any large number. The debt-equity ratio, as a measure of financial leverage, is more popular in practice. There is usually an accepted industry standard to which the company’s debt-equity ratio is compared. The company will be considered risky if its debt-equity ratio exceeds the industry standard. Financial institutions and banks also focus on debt-equity ratio in their lending decisions.


The first two measures of financial leverage are also measures of capital gearing. They are static in nature as they show the borrowing position of the company at a point of time. These measures, thus, fail to reflect the level of financial risk, which is inherent in the possible failure of the company to pay interest and repay debt.

The third measure of financial leverage, commonly known as coverage ratio, indicates the capacity of the company to meet fixed financial charges. The reciprocal of interest coverage, that is, interest divided by EBIT, is a measure of the firm’s income gearing. Again by comparing the company’s coverage ratio with an accepted industry standard, investors can get an idea of financial risk. However, this measure suffers from certain limitations. First, to determine the company’s ability to meet fixed financial obligations, it is the cash flow information, which is relevant, not the reported earnings. During recessionary economic decisions, there can be wide disparity between the earnings and the net cash flows generated from operations. Second, this ratio, when calculated on past earnings, does not provide any guide regarding the future risk ness of the company. Third, it is only a measure of short-term liquidity rather than of leverage.

(246)---MEANING OF FINANCIAL LEVERAGE

Meaning of Financial Leverage

As stated earlier, a company can finance its investments by debt and equity. The company may also use preference capital. The rate of interest on debt is fixed irrespective of the company's rate of return on assets. The company has a legal binding to pay interest on debt. The rate of preference dividend is also fixed; but preference dividends are paid when the company earns profits. The ordinary shareholders are entitled to the residual income. That is, earnings after interest and taxes (less preference dividends) belong to them. The rate of the equity dividend is not fixed and depends on the dividend policy of a company.


The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners' equity in the capital structure, is described as financial leverage or gearing or trading on equity. The use of the term trading on equity is derived from the fact that it is the owner's equity that it is used as a basis to raise debt ; that is, the equity that is traded upon. The supplier of the debt has limited participation in the company's profit and, therefore, he will insist on protection in earnings and protection in values represented by ownership equity.


The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus or deficit will increase or decrease the return on the owners' equity. The rate of return on the owners' equity is leverage above or below the rate of return on total assets. For example, if a company borrows 100$ at 8% interest and invests it to earn 12% return, the balance of 4% after payment of interest will belong to the shareholders, and it constitutes the profit from financial leverage. On the other hand, if the company could earn only a return of 6% on 100$, the loss to the shareholders would be 2$ per annul. Thus, financial leverage at once provides the potentials of increasing the shareholders' earnings as well as creating the risks of loss to them. It is a double-edged sword. The following statement very well summarises the concept of financial leverage.


The role of financial leverage suggests a lesson in physics, and there might be some point in considering the rate of interest paid as the fulcrum used in applying forces through leverage. At least it suggests consideration of pertinent variables; the lower the interest rate, the greater will be the profit, and the less the chance of loss; the less amount borrowed the lower will be the profit or loss; also, the greater the borrowing, the greater the risk of unprofitable leverage and the greater the chance of gain.

(245)---FINANCIAL AND OPERATING LEVERAGE

Financial and Operating Leverage

Introduction

The capital budgeting of a firm, it has to decide the way in which the capital projects will be financed. Every time the firm makes an investment decision, it is the same time making a financing decision also. For example, a decision to build a new plant or to buy a new machine implies specific way of financing that project. Should a firm employ equity or debt or credit? What are implies of the debt-equity mix? What is an appropriate mix of debt and equity?


Capital Structure Defined

The assets of a company can be financed either by increasing the owners' claims or the creditors claims. The owners' claims increase when the firm raises funds by issuing ordinary shares or by retaining the earnings; the creditors' claims increase by borrowing. The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firms capital expenditure, and therefore, the long-term claims are said to from the capital structure of the enterprise. The term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid up share capital, share premium and reserves and surplus.


The financing or capital structure decisions is a significant managerial decision. It influences the shareholder's return and risk. Consequently, the market value of the share may be affected by the capital structure initially at the time of its promotion. Subsequently, whenever funds have to be raised to finance investments, a capital structure decision is involved. A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing. This decision will involve an analysis of the existing capital structure and the factors, which will govern the decision at present. The dividend decision, is, in a way, a financing decision. The company's policy to retain or distribute earnings affects the owners' claims. Shareholders' equity position is strengthened by retention of earnings. Thus, the dividend decision has a financing decision of the company may affect its debt-equity mix. The debt-equity mix has implications for the shareholders' earnings and risk, which in turn, will affect the cost of capital and the market value of the firm.


The management of a company should seek answers to the following questions while making the financing decision:

• How should the investment project be financed?
• Does the way in which the investment projects are financed matters?
• How does financing affect the shareholders' risk, return and value?
• Does there exist an optimum financing mix in terms of the maximum value of the firms shareholders?
• Can be optimum financing mix be determined in practice for a company?
• What fact ores in practice should a company consider in designing its financing policy?