The expense of debt financing is interest, a fixed charge dependent on the amount of financial principal and the rate of interest. Interest is a contractual obligation created by the borrowing agreement. In contrast to dividends, interest must be paid regardless of whether the firm is in a highly profitable period or not. An advantage of interest over dividends is its tax deductibility. Because the interest is subtracted to calculate taxable income, income tax expense is reduced.
Definition of Financial Leverage and Magnification Effects
The use of financing with a fixed charge (such as interest) is termed financial leverage. Financial leverage is successful if the firm earns more on the borrowed funds than it pays to use them. It is not successful if the firm earns less on the borrowed funds than it pays to use them. Using financial leverage results in a fixed financing charge that can materially affect the earnings available to the common shareholders.
Figure illustrates financial leverage and its magnification effects. In this illustration, earnings before interest and tax for the Dowell company are $1,000,000. Further, the firm has interest expense of $200,000 and a tax rate of 40%. The statement illustrates the effect of leverage on the return to the common stockholder. At earnings before interest and tax (EBIT) of $1,000,000, the net income is $480,000. If EBIT increases by 10% to
$1,100,000, as in the Figure, the net income rises by 12.5%. This magnification is caused by the fixed nature of interest expense. While earnings available to pay interest rise, interest remains the same, thus leaving more for the residual owners. Note that since the tax rate remains the same, earnings before tax change at the same rate as earnings after tax. Hence, this analysis could be made with either profit figure.
If financial leverage is used, a rise in EBIT will cause an even greater rise in net income, and a decrease in EBIT will cause an even greater decrease in net income. Looking again at the statement for the Dowell Company in Figure, when EBIT declined 20%, net income dropped from $480,000 to $360,000—a decline of $120,000, or 25%, based on the original $480,000.
The use of financial leverage, termed trading on the equity, is only successful if the rate of earnings on borrowed funds exceeds the fixed charges.
Computation of the Degree of Financial Leverage
The degree of financial leverage is the multiplication factor by which the net income changes as compared to the change in EBIT. One way of computing it follows:
The degree of financial leverage is 1.25. From a base EBIT of $1,000,000, any change in EBIT will be accompanied by 1.25 times that change in net income. If net income before interest and tax rises 4%, earnings to the stockholder will rise 5%. If net income before interest and tax falls 8%, earnings to the stockholder will decline 10%. The degree of financial leverage (DFL) can be computed more easily as follows:
Note that the degree of financial leverage represents a particular base level of income.The degree of financial leverage may differ for other levels of income or fixed charges. The degree of financial leverage formula will not work precisely when the income statement includes any of the following items:
When any of these items are included, they should be eliminated from the numeratorand denominator. The all-inclusive formula follows:
This formula results in the ratio by which earnings before interest, tax, minority share of earnings, equity income, and nonrecurring items will change in relation to a change in earnings before tax, minority share of earnings, equity income, and nonrecurring items. Inother words, it eliminates the minority share of earnings, equity income, and nonrecurring items from the degree of financial leverage.
Figure shows the degree of financial leverage for 1999 and 1998 for Nike. The degree of financial leverage is 1.06 for 1999 and 1.09 for 1998. This is a very low degree of financial leverage. Therefore, the financial leverage at the end of 1999 indicates that as earnings before interest changes, net income will change by 1.06 times that amount. If earnings before interest increases, the financial leverage will be favorable. If earnings before interest decreases, the financial leverage will be unfavorable. In periods of relatively low interest rates or declining interest rates, financial leverage looks more favorable than in periods of high interest rates or increasing interest rates.
Summary of Financial Leverage
Two things are important in looking at financial leverage as part of financial analysis. First, how high is the degree of financial leverage? This is a type of risk (or opportunity) measurement from the viewpoint of the stockholder. The higher the degree of financial leverage, the greater the multiplication factor. Second, does the financial leverage work for or against the owners?
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