Financial Leverage

7 Key excerpts on "Financial Leverage"

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  eBook - PDF

  Financial Analysis with Microsoft Excel

  • Timothy Mayes(Author)
  • 2020(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  In finance, leverage refers to a multiplication of changes in prof- itability measures. For example, a 10% increase in sales might lead to a 20% increase in net income. 3 The amount of leverage depends on the amount of debt that a firm uses to finance its operations, so a firm that uses a lot of debt is said to be “highly leveraged.” 3. As we will see in Chapter 7, this would mean that the degree of combined leverage is 2. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 3 Financial Statement Analysis Tools 84 Leverage ratios describe the degree to which the firm uses debt in its capital structure. This is important information for creditors and investors in the firm. Creditors might be concerned that a firm has too much debt and will therefore have difficulty in repaying loans. Investors might be concerned because a large amount of debt can lead to high volatility in the firm’s earnings. However, most firms use some debt because the tax deductibility of interest can increase the stock price. We will examine several ratios that measure the amount of debt that a firm is using. How much is too much depends on the nature of the business.

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  eBook - ePub

  Basic principles of financial management

  • Brümmer LM, Hall JH, Du Toit E(Authors)
  • 2017(Publication Date)
  • Van Schaik Publishers

    (Publisher)

  An extension of the study of capital structure, after investigating the EBIT-EPS approach, would be to include the concept of Financial Leverage and its implications. In studying this concept, we shall observe the implications of varying capital structures in attempts to boost returns to owners, and also the implications of the financial risk associated with such variations will become evident. This concept will be discussed in the following section.

  Financial Leverage

  Introduction

  The concept of total leverage consists of two sub-concepts or levers. The first one (the primary lever) is called operating leverage, and the second (the secondary lever) is called Financial Leverage. Because of their relatively close conceptual relationship, these two sub-concepts are often discussed together. However, in order to preserve the continuity in our discussion of capital structure and Financial Leverage in this chapter, operating leverage will be discussed in the next chapter (Chapter 13 ).

  The main reason for this departure from normal practice is that Financial Leverage is more closely related to capital structure than is operating leverage, which is why they are being discussed in this chapter. In order to preserve the relationship between operating and Financial Leverage, however, there will be a certain amount of repetition in Chapter 13 to aid cross-reference. For example, the definition of Financial Leverage will be given in this section and repeated when we discuss operating leverage so that we do not lose sight of the relationship between the two concepts constituting total leverage. 212

  The reason for employing Financial Leverage

  Why would an organisation apply the principle of Financial Leverage? The answer is: in order to maximise returns to owners. This practice is followed by both creditor and debtor organisations. Consequently, knowledge of the risk implications in Financial Leverage is important to all financial managers and investors when they examine the financial position of an investment prospect.

  It is generally accepted in financial circles that maximising owners’ wealth is to be preferred to maximising profits. Nevertheless, the role of capital structure is of paramount importance in both instances of wealth and of maximising profitability. In either instance, a discussion of Financial Leverage becomes necessary.

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  eBook - PDF

  Corporate Finance

  Economic Foundations and Financial Modeling

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton, Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  Depicting a broader array of capital structures and operating earnings, ranging from an operating loss of $500,000 to operating earnings of $2,000,000, Exhibit 12 shows the effect of leverage on the return on equity for Capital Company: 204 The Corporation: Operating, Investing, and Financing Activities EXHIBIT 12: Return on Equity of Capital Company for Different Levels of Operating Earnings and Different Financing Choices –100% –50% 50% 0% 100% 150% 200% 250% 300% –$500,000 –$100,000 $300,000 $700,000 $1,100,000 $1,500,000 $1,900,000 Earnings before Interest and Taxes Return on Equity Debt to total assets = 0% Debt to total assets = 33.33% Debt to total assets = 50% Debt to total assets = 67% Business is generally an uncertain venture. Changes in the macroeconomic and competitive environments that influence sales and profitability are typically difficult to discern and forecast. The larger the proportion of debt in the financing mix of a business, the greater is the chance that it will face default. Similarly, the greater the proportion of debt in the capital structure, the more earnings are magnified upward in improving economic times. The bottom line? Financial Leverage tends to increase the risk of ownership for shareholders. 6. TOTAL LEVERAGE AND THE DEGREE OF TOTAL LEVERAGE The degree of operating leverage gives us an idea of the sensitivity of operating income to changes in revenues. And the degree of Financial Leverage gives us an idea of the sensitivity of net income to changes in operating income. But often we are concerned about the combined effect of both operating leverage and Financial Leverage. Owners are concerned about the combined effect because both factors contribute to the risk associated with their future cash flows.

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  eBook - PDF

  Basic Finance

  An Introduction to Financial Institutions, Investments, and Management

  • Herbert Mayo, , , (Authors)
  • 2018(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  This conclusion is derived from several important assumptions, one of which is that if a firm uses too little Financial Leverage, investors can substitute their own leverage for the firm’s leverage. Consider a firm with no debt financing. Inves-tors can borrow money to buy the stock (that is, buy the stock on margin). In such a case, the stockholders are substituting their own leverage for the firm’s use of finan-cial leverage. If the firm uses a large amount of Financial Leverage, the stockholders can then hold portfolios of cash and the stock, which reduces the impact of the firm’s large use of Financial Leverage. By having stockholders alter their portfolios to offset a firm’s use of Financial Leverage, one can reason that an optimal capital structure is irrelevant. What is important is the operating income the firm generates, and not how that income is divided between creditors in the form of interest payments and owners in the form of dividends and capital gains. All assets must be financed. While there may be a variety of securities, there are ul-timately only two sources: debt and equity. If the firm uses debt financing or pre-ferred stock financing, it is financially leveraged. If the firm uses Financial Leverage, it increases risk, which may increase the cost of the components of the firm’s capital structure. One component of the capital structure, the cost of debt, depends on the interest rate that must be paid and the tax saving associated with the deductibility of interest payments. Another component, the cost of preferred stock, depends on the dividend that is paid and the net proceeds from the sale of the preferred stock. The third component, the cost of common equity, depends on whether the firm uses retained earnings or issues new shares of stock. New equity is more expensive because of the flotation costs associated with the sale of the new shares.

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  eBook - ePub

  Financial Management for Nonprofit Organizations

  Policies and Practices

  • John Zietlow, Jo Ann Hankin, Alan Seidner, Tim O'Brien(Authors)
  • 2018(Publication Date)
  • Wiley

    (Publisher)

  An important element in the pricing of debt is the relationship between risk and reward: The greater the risk, the greater the reward. The lender or bond investor is willing to risk the possible loss of money in return for monetary rewards. The “junk,” or high-yield, bond market that developed during the 1980s illustrates the lender's perspective. An organization that wants to issue long-term bonds but that does not have an investment-grade rating (the top four creditworthiness rating categories, AAA, AA, A, and BBB in Standard and Poor's framework, are considered investment grade) must issue noninvestment-grade bonds and pay a higher return to attract the needed funds than would an investment-grade company. This same relationship holds true when tax-exempt bonds are issued by charities. When managing debt, a financial manager must assess the level of risk that the organization presents to a financing source, the resulting availability of financing, and the cost that the financing will carry. Return to the bond investor or lender represents cost to the borrower.

  (ii) Leverage. Leverage is defined as the use of another person's or organization's financial resources. The more leverage (the greater the proportion of debt to equity, or net assets) that an organization has – the greater the risk to the organization and to the lender that the organization will be vulnerable to the impact of external factors. So think of equity, or net assets, as a cushion for the lender or bond investor. The effects of external factors, such as recessions, unemployment, and interest rates, are magnified by leverage, sometimes positively and sometimes negatively.

  The amount of leverage that a nonprofit organization can take on without risking future loss of control to the organization's lenders varies. For example, in the nursing home and home healthcare industries, markets must be served; lenders can be instrumental in forcing changes where existing management demonstrates lack of ability. Where the market already is well served, lenders are usually inclined to limit their losses by simply closing down an inefficient or ineffective business. Financial managers can get a good idea of where they stand in the eyes of a lender familiar with the nonprofit industry by studying the financial statements of other nonprofit organizations in similar service arenas. Doing this will also assist financial managers in determining the financial alternatives available. Illustrating, it is much easier to be approved for a short-term loan or credit line if the nonprofit offers collateral such as inventories or receivables in the form of government contract payments (although this might be arguable in some states where government fiscal irresponsibility has severely slowed payments), tuition payments, or grant proceeds. Absent these normal forms of short-term loan collateral, some nonprofits borrow using a personal guarantee from a manager or board member or using the building as collateral. Nonbank sources of loans, including loans from board members, may fill in the gap when bank sources are unavailable.

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  eBook - ePub

  Kickstart Your Corporation

  The Incorporated Professional's Financial Planning Coach

  • Andrew Feindel(Author)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  In a nutshell, borrowing money to invest is like doing what banks do. Banks take the money we deposit, pay us an interest rate, and then go off and invest in something else, generating a potentially higher rate of return. It's known as the concept of using other people's money (OPM).

  The most important aspect of leverage is that it is a blade that cuts both ways: it can offer massive financial benefits or become a major financial burden. The key is to use leverage prudently, investing wisely in the appropriate investment accounts within disciplined and certain time frames, and to make sure that it is suitable for your specific risk tolerance.

  Leveraging can be used to improve your long-term effective rate of return within your corporation assets, or help build your non-registered assets.

  In this chapter, we explore how leverage can enhance returns in the corporation, assist in removing funds outside of the corporation with offsetting deductions, and make your mortgage tax deductible—but we'll also look at the downside of leveraging.

  What You'll Get Out of This Chapter

  In this chapter, we review the ins and outs of borrowing to invest, also known as the use of leverage.

  We review who is a suitable candidate for the use of leverage, and what products and strategies may allow you to benefit from leverage—and importantly, we also review when and for whom leverage is not appropriate, including some cautionary tales from real-life examples we've seen.

  You will leave this chapter with a good overview of how to use leverage to your advantage, and when to steer clear.

  First, let's review the pros and cons of leveraging. Pros of Leveraging

  • It may increase your effective returns.
  • Your investments start working for you right away, as opposed to waiting the time it takes to save the same amounts.
  • Borrowing money to invest allows you to create a tax deduction for interest costs.
  • Behavioural finance principle: Leverage creates a forced savings plan, which forces you to be disciplined in your saving, perhaps resulting in less impulsive spending.

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  eBook - PDF

  QuickBooks 2022 All-in-One For Dummies

  • Stephen L. Nelson(Author)
  • 2021(Publication Date)
  • For Dummies

    (Publisher)

  Leverage Ratios Leverage ratios measure how much debt a firm carries and how easily a firm pays the interest expenses of carrying that debt. Leverage ratios are important for an obvious reason: Typically, a firm financed mostly with debt needs to continue to borrow to stay in business. (If this doesn’t make sense, think about what happens if a bank won’t extend a loan or won’t refinance a mortgage to a firm that’s heav -ily dependent on debt!) What’s more, a firm that carries a lot of debt typically also spends a lot of money on interest expense. The heavy interest expense means that it’s especially impor -tant for such a firm to have adequate operating income. Operating income is the income available to pay interest and other profits. A firm with a lot of operating income relative to its interest expense doesn’t have much of a problem paying the interest — and this is true even if operating income declines or decreases. By contrast, a firm with very modest operating income relative to its interest expense quickly gets into trouble if the operating income decreases. Debt ratio The debt ratio simply shows the firm’s debt as a percentage of its capital struc -ture. The term capital structure refers to the total liabilities and owner’s equity amount. In the case of the balance sheet shown in Table 1-1, the capital structure totals $320,000. Not coincidentally, the total liability and owner’s equity amount ($320,000) equals the total assets amount ($320,000). This makes sense if you think about it a bit. A firm funds its assets with its capital. Therefore, the total assets always equal the total capital structure.

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