Understanding Financial and Operational Leverages

When a company wants to increase its investments in order to expand its asset base and generate returns towards risk capital, it sometimes borrows capital as a funding source. This is known as Leverage. Leverage is an investment strategy of using borrowed money, specifically from financial instruments or borrowed capital, to increase its potential rate of returns on equity. Leverage also refers to the amount a company borrows or the debt it uses to purchase or finance assets.

Just as a lever is used to increase a person's chances of lifting a heavyweight item, leverages can be used to increase the chances of getting better and higher returns towards an investment.

Importance of Leverage to companies and investors

Both companies and investors use financial leverages. A company uses Leverage to finance its assets instead of issuing stock to raise capital. It also uses debts to invest in its business operations to increase returns for its stockholders. 

Leverage is the use of borrowed capital or debt by a company in the business operations, with the purpose of increasing the rate of returns for its shareholders. At the same time, Leverage can also increase the chances of potential risks to its securities; in case the investment strategy does not work out. If a company or a property or an investment is referred to as being "highly leveraged," it means that it has more debt than equity.

The investors use Leverage to increase or multiply their buying power in the market. They use it to increase the returns that can be generated out of an investment. Investors can apply leverages on their investments, directly or indirectly. For indirect Leverage, they can invest in companies that use Leverage in their day-to-day business to finance or expand operations, without increasing their expenses.

Working of Leverage

When a company plans on increasing its asset base by financing more assets, it usually has three options for financing- using equity, debt, or leases. However, except for equity, the rest of the financing options include fixed costs lower than the income that the company expects to generate from the asset usage. Hence, we can assume that the company uses debt to finance its asset acquisition.

Types of Leverages: Financial and Operational Leverages

Usually, investors study the balance sheet of a company to understand its debt and equity situation. Through this study, they can understand which companies use the Leverage efficiently and invest accordingly.

Financial figures such as return on equity (ROE) and return on capital employed (ROCE) help investors determine how companies use their existing capital and how much of that capital companies have borrowed. Hence, to evaluate these statistics, it is important to remember that Leverage has different types, including operating, financial, and combined Leverage.

1. Operational Leverage

The basic analysis uses the degree of operating Leverage, which is a measure that indicates the change in a company's operating income with respect to its change in sales. Companies, which have a large proportion of fixed costs as compared to their variable costs, have a higher level of operating Leverage.

Operational Leverages measure a company's fixed costs as a percentage of its total costs. It indicates a company's break-even point, where the sales are high enough to pay for all the costs, so the profit is zero.

A company that has high operating Leverage usually has a large amount of fixed costs, which indicates that a big rise in sales can lead to heavy changes in profits. A company with low operating Leverage has large variable costs, which means that it earns a smaller profit on each sale. However, it does not have to increase its sales in order to cover its low fixed costs.

Degree of Operational Leverages

A risk involved in the business is often measured with the degree of operating Leverage. DOL measures how a percentage change in a company's sales will affect its profits. It is a function that establishes the relationship between a company's costs, fixed and variable.

DOL = Contribution Margin (CM) / Earnings before Interest and Tax (EBIT),

where Contribution Margin (CM) = Sales - All Variable costs

For example, Company ABC Ltd. has registered total sales of Rs 1000. The total costs incurred are Rs 914, out which fixed cost is Rs 814, and the variable cost is Rs 100. The operating profit before any deductions was Rs 86.

Hence, Contribution Margin of ABC Ltd = 1000-100 = 900

DOL of ABC Ltd = CM / EBIT

                          = 900/84

                          = 10.7

2. Financial Leverage

The "equity multiplier" or financial Leverage is an important factor or component of the DuPont analysis. It is the ratio of the average total assets of the company as compared to its average equity. The financial Leverage is then multiplied with the return on assets to calculate the company's return on equity.

Financial Leverage = Average total assets / average total equity

For example, if a company has total assets valued at Rs 50,000 and shareholder equity valued at Rs 25,000, then the equity multiplier or financial Leverage will be 2.0 (50000/ 25000). This indicates that the company has financed half its total assets through equity. Hence, a higher equity multiplier indicates more financial Leverages.

The company ABC Ltd has total equity of Rs 300 and a debt of Rs 200, which makes it total assets worth Rs 500.

Hence, the Financial leverage of ABC Ltd = 500/300  = 1.6 or 16%

Degree of Financial Leverage

There is another important concept to Leverage, which is known as the degree of financial Leverage. A company's financial risk is usually measured by the degree of financial leverages. The degree of financial Leverage is defined as the change in the net income with respect to the change in operating income or earnings before interest and tax.

DFL = %change in net income / %change in operating income

Example of Leverage: Operational and Financial

Suppose ABC Ltd has issued 20 common stocks (Rs 100 par) and has a debt of Rs 500 @10% interest.

Company XYZ Co. has issued ten common stocks (Rs100 par) and has a debt of Rs 1500 @ 10% interest.

At Rs 1000 sales, both the companies have the same level of Rs 200 EBT (earnings before tax). Comparing the income statement of both the companies, assuming a 25% increase in sales:

Degree of Operational Leverage (DOL) = 2.00

Degree of Financial Leverage (DFL) = 1.33

Degree of Total Leverage (DTL) = %change in EPS/ % change in sales

                                                    = 67/25 =2.67

Income Statement of XYZ Co (Increase in 25% Sales)

Degree of Operational Leverage (DOL) = 3.50

Degree of Financial Leverage (DFL) = 4.00

Degree of Total Leverage (DTL) = 14.00

Now, let’s compare the Income statements of both the companies assuming a 25% decrease in sales:

Income Statement of ABC Ltd (with 25% decrease in sales)

Degree of Operational Leverage (DOL) = 2.00

Degree of Financial Leverage (DFL) = 1.33

Degree of Total Leverage (DTL) = 2.67

Income Statement of XYZ Co. (With 25% decrease in sales)

Degree of Operational Leverage (DOL) = 3.50

Degree of Financial Leverage (DFL) = 4.00

Degree of Total Leverage (DTL) = 14.00

With the above example, we get an idea about the advantages as well as the limitations of leverage.

Advantages of Leverage

A company will resort to adding leverages in order to either increase its assets base or with the purpose of increasing the returns for its investors. Similarly, for investors, they want to increase their chances of earning better returns; hence they acquire Leverage for their investments. Adding Leverage to the investment or taking up Leverage comes up with advantages:

• It is a powerful access to capital. Leverage multiplies the power of the money that has been put on the investment. If used efficiently, Leverage can significantly increase the returns on investment as opposed to without Leverage.
   
• It is ideal for more acquisitions and buyout. Due to some additional cost and risks of increasing debts, Leverage is useful for short periods when a business has a specific small-term objective, such as conducting an acquisition, management buyout, share buyback, or a one-time dividend.

Limitations of Leverages

With the many advantages and positivity it brings, Leverage is basically just another form of debt. It comes with the following limitations:

• It is a risky source of finance. The higher the Leverage, the riskier the investment becomes.
• Leverage is a costlier source of finance. Leveraged loans and bonds have higher interest rates to compensate investors for a higher risk involved.
• The financial instruments involved in the evaluation of leverages make it more complicated and require more attention and time. It also involves various risks.
• Leverage shows increased or magnified gains and losses. If an investor uses Leverage for investment purposes, their loss is comparatively much higher than it would've been if Leverage had not been used.

The Bottom Line

In conclusion, leverages are a strong source of increasing returns on investments and acquiring assets for investors and companies. However, it is still a form of debt and naturally comes with a heavy set of risks and limitations.

It is advisable for first-time investors to avoid getting leverages for their investments as the risks are heavy, and returns are always dicey. A company can use Leverage to increase its shareholders' wealth, but the interest expense and credit risk can destroy the shareholders' value if it fails.

The application of leverages, both finance and operation, should be done with the utmost care and after a thorough analysis in order to make the most efficient use out of it, and increase the chances of generating profitable returns.