101: Financial Leverage

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In a Operating Leverage post we demonstrated that increasing a firm’s operating leverage, by replacing variable costs with fixed costs, could lead to greater profits; but that it also increased the firm’s risk level. This week, as promised, we’ll take a look at financial leverage and see how the mix of debt and equity financing affects risk and return.

As you may recall from our piece about capital structure, all of the money that you raise for your firm will come in the form of either debt or equity. If you are using any amount of debt financing (i.e. borrowing money) then you are employing financial leverage. If all the money you’ve raised is in the form of equity, then your company is not using any financial leverage.

Financial leverage, like operating leverage, increases a firm’s chance to raise its level of profits, but also leads to greater risk. So when it comes time to raise funds, how do we assess whether to use debt or equity? We can begin with a simple example that demonstrates how the choice between debt and equity affects the owners’ return on their investment (known in the financial parlance as the return on equity or ROE).

For this example we’ll assume that a company needs to raise $100,000, that it can borrow up to $40,000 at a 5% interest rate, and that it pays corporate income taxes at a 40% rate.

 

Scenario 1: 100% Equity Financing

       
Balance Sheet      
Assets   Liabilities and Equity  
Cash

 $100,000

Equity

 $100,000

       
Income Statement      
       
Sales

 $100,000

   
Expenses

 $80,000

   
Earnings before interest and taxes (EBIT)

 $20,000

   
Taxes (40% Rate)

 $8,000

   
Net Earnings

 $12,000

   
       
Return on Equity

12%

   
       

Scenario 2: 60% Equity Financing, 40% Debt Financing @ 5% Interest Rate

       
Balance Sheet      
Assets   Liabilities and Equity  
Cash

 $100,000

Debt

 $40,000

    Equity

 $60,000

Income Statement      
       
Sales

 $100,000

   
Expenses

 $80,000

   
Earnings before interest and taxes (EBIT)

 $20,000

   
Interest Expense

 $2,000

   
Taxable Income

 $18,000

   
Taxes (40% Rate)

 $7,200

   
Net Earnings

 $10,800

   
       
Return on Equity

18%

   

 

In Scenario 1 the company elects not to issue any debt and winds up with net earnings of $12,000 for a return on equity of 12%. In Scenario 2 this same company elects to raise 40% of its required funds ($40,000) with debt and winds up with lower net earnings of $10,800 but a significantly higher return on equity of 18%. What happened? How does issuing debt and thereby reducing earnings lead to a higher return on equity?

The answer lies in the fact that under Scenario 2 the company’s owners only invested $60,000 of their own money, instead of the $100,000 invested under Scenario 1, and were able to earn $10,800 or 18% on that investment. So, this demonstrates one of the two key points we made earlier about financial leverage: that its use can increase a firm’s level of profitability.

And there are actually two important factors at work driving this increased ROE. First is that the firm was able to borrow money at 5% and to earn more than that through its core business activities. Second, and perhaps more importantly, is the fact that the company doesn’t have to pay taxes on its interest expenses. It is largely because of this tax advantage that so many companies choose to raise a portion of their financing via debt.

But, as in all cases involving risk and return, the increased returns associated with financial leverage also carry increased risks. Just as financial leverage can increase owners’ return on equity during the good times; it can lead to dramatic, and potentially fatal, reductions in ROE during difficult times. If a firm takes on too much debt in an effort to jack up ROE and things take a turn for the worse, it may be forced to declare bankruptcy if it can’t afford to pay back that debt.

So when it comes time to choose between debt and equity for your company, remember to analyze carefully the potential effects on both your return and your risk, and to consult with accounting or finance professionals before making any final decisions.

More By Gregg Schoenberg
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