What is Financial Leverage Ratio?
Financial leverage ratio helps in determining the effect of debt on the overall profitability of the company – high ratio means the fixed cost of running the business are high, whereas, lower ratio implies lower fixed cost investment in the business.
In simple terms, It indicates how much a business is dependent on the debt that it has issued and how the company is using debt as a part of its financing strategy and its dependency on borrowings.
Pepsi’s Financial Leverage was around 0.50x in 2009-2010, however, Pepsi’s leverage has increased over the years and is currently at 3.38x.
What does this mean for Pepsi? How did its Debt to Equity Ratio increase dramatically? Is this good or bad for Pepsi?
Financial Leverage Formula
- The term leverage, in the field of business, refers to the use of different financial instruments or borrowed capital in order to increase the firm’s potential ROI or return on investment.
- When given a generalized and more technical definition, the financial leverage ratio is the extent up to which a firm utilizes the available financial securities, such as equity and debt. It indicates the extent of reliance on a firm’s business over the available debt in the firm’s business operations.
The formula of financial leverage with regards to a company’s capital structure can be written as follows:
Please note that Total Debt = Short Term Debt + Long Term Debt.
- The higher the value of leverage, the more that particular firm uses its issued debt. A large value for leverage means a much higher interest rate, resulting in higher interest expenses. And this can negatively affect the firm’s bottom line and earnings per share.
- But at the same time, the leverage value should not go down too low, as the firms issuing too much equity is considered less secure because the amount of risk in equity markets is too high.
- So in a way, leverage is also an effective way to understand and analyze financial risks faced by an organization in its business. Financial risk is a single word used as a general term for several kinds of risks associated with the finances of a business.
- These risks include all the risks involving monetary transactions, such as company loans, and its exposure to loan default. The term is often used to reflect an investor’s uncertainty regarding the collection of returns and also the potential of a financial loss.
Also, check out this detailed article on Operating Leverage
Nestle Financial Leverage Example
Below is the excerpt of the Balance sheet of Nestle with 2014 and 2015 financials. Let us calculate Nestle’s Leverage here.
source: Nestle Annual Report
From the table above –
- Current Portion of Debt = CHF 9,629 (2015) & CHF 8,810 (2014)
- Long Term Portion of Debt = CHF 11,601 (2015) & CHF 12,396 (2014)
- Total Debt = CHF 21,230 (2015) & CHF 21,206 (2014)
- Total Shareholders Equity to the Parent = CHF 62,338 (2015) & CHF 70,130 (2014)
Formula = Total Debt / Shareholder’s Equity
| In millions of CHF | 2015 | 2014 |
| Total Debt (1) | 21230 | 21206 |
| Total Shareholder’s Equity (2) | 62,338 | 70,130 |
| Total Debt to Shareholder’s Equity | 34.05% | 30.23% |
Leverage has increased from 30.23% in 2014 to 34.05% in 2015.
Also, have a look at these ratios –
Oil & Gas Companies Example (Exxon, Royal Dutch, BP & Chevron)
Below is the graph of Exxon, Royal Dutch, BP, and Chevron.
source: ycharts
The leverage of the Oil and Gas Sector, in general, has increased. It all started primarily from 2013-2014 when the slowdown in commodity began, which not only resulted in reduced cash flows but also led these companies to borrow thereby straining their balance sheet.
Why Marriott International Financial Leverage Increased Drastically?
Why do you think Leverage has increased drastically?
source: ycharts
Did Marriott Raise Large Amounts of Debt?
Let us analyze this question by pulling out the relevant section of Marriott 2016 10K
source: Marriott International SEC Filings
Marriott Current Portion of Long Term Debt increased marginally to $309 million in 2016 as compared to $300 million in 2015. However, its long term debt increased by 115% in 2016 to $8,197 million. This is one of the primary reasons for a big jump in leverage.
Investigating Shareholder’s Equity
Did Shareholder Equity decrease? No, It didn’t.
Do have a look at snapshot below of Shareholder’s Equity of Marriott Internation.
source: Marriott International SEC Filings
We note that Shareholder’s Equity of Marriott International has increased from a -$3,590 million in 2015 to $5357 million in 2016. The increase was primarily due to Marriott common stock and equity-based awards issued in the Starwood Combination.
Therefore we can conclude that the increase in a Leverage ratio of Marriott was a result of Higher Debt.
What is the Degree of Financial Leverage?
The Degree of Financial Leverage, or in short DFL, is calculated with a different formula from the one that is commonly used for the calculation of leverage value of an organization.
DFL is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to the fluctuations in its operating financial gain, because of the changes in its capital structure. DFL measures the percentage of change in EPS for a unit change in earnings before interest and taxes (EBIT).
DFL can be calculated by using the formula given below:
The ratio shows that the more the value, the more volatile is the EPS. Since interest is a fixed expense, leverage magnifies returns and EPS, which is good in situations where the operating income is rising. However, it is unfavorable in bad economic times when the operating income is declining.
Accenture Example
Let us look at Accenture example to get an understanding of the calculation of the Degree of Financial Leverage ratio. Below is the Income Statement of Accenture pulled from its SEC Filings.
source: Accenture SEC Filings
Degree of Financial Leverage Formula = % change in EPS / % change in EBIT
ACCENTURE – 2016
- % change in EPS (2016) = (6.58 – 4.87)/4.87 = 35.2%
- % change in EBIT (2016) = (4,810,445 – 4,435,869)/4,435,869 = 8.4%
- Accenture’s Leverage (2016) = 35.2% / 8.4% = 4.12x
ACCENTURE – 2015
- % change in EPS (2015) = (4.87 – 4.64 )/4.64 = 5.0%
- % change in EBIT (2015) = (4,435,869 – 4,300,512)/4,300,512 = 3.1%
- Accenture’s leverage (2015) = 5.0% /3.1% = 1.57x
We note that Accenture’s Leverage Ratio in 2015 was 1.57x, however, it increased to 4.12x in 2016. Why?
- There is something not right about our calculation of leverage ratio of 2016. If you look closely at the Accenture’s 2016 Income Statement, we note that there is Gain on Sale of Business of $848,823 added after Operating Income (EBIT). This gain doesn’t occur in previous years.
- If we want to make an apple to apple comparison, we should have deducted this gain on Sale of Business and normalized the EPS. This normalized EPS should’ve been used for the Leverage Ratio calculations.
Please note that the Degree of Financial leverage ratio is thus extremely valuable for helping an organization assess the quantity of debt or leverage it ought to choose in its capital structure. If operating financial gain is comparatively stable, then earnings and EPS (Earnings Per Share) would be stable as well, and the company will be able to afford to take a large amount of debt. However, if the firm operates in a sector where operating financial gain is kind of volatile, it may be prudent to limit the debt to easily manageable levels.
Utilities Sector Example
The below table provides us with the list of top Utility companies along with their Market Cap, Leverage, EBIT and EPS Growth and Degree of Financial Leverage.
| S. No | Name | Market Cap ($ mn) | Leverage | EBIT (YoY Growth) | EPS ( YoY Growth) | Leverage |
| 1 | Dominion Energy | 48,300 | 2.40x | 2.6% | 7.2% | 2.78x |
| 2 | Exelon | 48,111 | 1.39x | -29.4% | -51.8% | 1.76x |
| 3 | Dominion Energy | 30,066 | 2.40x | 2.6% | 7.2% | 2.78x |
| 4 | Public Service Enterprise | 22,188 | 0.90x | -46.8% | -47.0% | 1.00x |
| 5 | Avista | 3,384 | 1.12x | 14.4% | 9.1% | 0.63x |
| 6 | Cosan | 1,914 | 2.94x | -10.2% | -35.4% | 3.48x |
source: ycharts
- We note that the higher the financial leverage, the higher is the degree of Financial Leverage.
- Dominion Energy has a leverage Ratio of 2.40x and its degree of operating leverage is 2.78x
- The leverage of Public Service Enterprise is 0.90x (lower as compared to its peer group). Due to its lower leverage ratio, its leverage is at 1.0x.
Telecom Example
Below table provides data for Telecom companies along with other leverage details
| S. No | Name | Market Cap ($ mn) | Leverage | EBIT (YoY Growth) | EPS ( YoY Growth) | Degree of Financial Leverage |
| 1 | America Movil | 58,613 | 3.41x | -34.2% | -78.8% | 2.30x |
| 2 | Telefonica | 54,811 | 3.32x | 54.7% | 498.4% | 9.11x |
| 3 | American Tower | 58,065 | 2.74x | 14.9% | 40.8% | 2.74x |
| 4 | T-Mobile US | 51,824 | 1.52x | 84.1% | 106.0% | 1.26x |
| 5 | BT Group | 40,371 | 1.50x | -24.0% | -41.6% | 1.73x |
| 6 | Cable One | 4,293 | 1.18x | 16.4% | 13.3% | 0.81x |
| 7 | Nortel Inversora | 4,455 | 1.10x | -21.6% | -27.7% | 1.28x |
| 8 | China Unicom | 35,274 | 0.77x | -76.4% | -93.6% | 1.22x |
| 9 | KT | 8,848 | 0.71x | 21.2% | 26.4% | 1.24x |
| 10 | Telecom Argentina | 5,356 | 0.62x | -21.5% | -27.2% | 1.26x |
| 11 | Tim Participacoes | 7,931 | 0.40x | -58.7% | -66.0% | 1.12x |
| 12 | Telekomunikasi Indonesia | 34,781 | 0.33x | 21.8% | 25.3% | 1.16x |
| 13 | ATN International | 1,066 | 0.24x | -36.6% | -29.2% | 0.80x |
source: ycharts
- Overall, the sector doesn’t have consistent leverage and degree of operating leverage across companies
- America Movil has a high leverage of 3.41x, due to which it has a higher leverage of 2.30.
- Telefonica also have high leverage of 3.32x, however, it has an even higher Leverage of 9.11x
- ATN International has a leverage of 0.24x and its degree of financial leverage is 0.80x
Technology Example
The below table provides us with some of the top tech companies.
| S. No | Name | Market Cap ($ mn) | Leverage | EBIT (YoY Growth) | EPS ( YoY Growth) | Degree of Financial Leverage |
| 1 | Alphabet | 658,717 | 0.03x | 22.5% | 22.5% | 1.00x |
| 2 | NetEase | 40,545 | 0.10x | 63.9% | 63.0% | 0.99x |
| 3 | SINA | 6,693 | 0.08x | 499.5% | 644.2% | 1.29x |
| 4 | YY | 4,064 | 0.55x | 43.9% | 38.5% | 0.88x |
| 5 | Web.com Group | 1,171 | 2.82x | -27.6% | -95.5% | 3.47x |
source: ycharts
- Alphabet has a nominal debt and its leverage is 0.03x. Its degree of Financial leverage ratio is 1.00x. This means that the % change of EBIT is exactly the same as % change in EPS.
- Likewise, Netease also has a lower leverage of 0.10x. Its ratio is 0.99x.
Business Services Example
Below table provides the details of the Business Services sector along with its Market Cap and other details
| S. No | Name | Market Cap ($ mn) | Leverage | EBIT (YoY Growth) | EPS ( YoY Growth) | Degree of Financial Leverage Ratio |
| 1 | Automatic Data Processing | 46,164 | 0.50x | 8.8% | 6.5% | 0.74x |
| 2 | Fiserv | 26,842 | 1.80x | 10.2% | 38.8% | 3.80x |
| 3 | Equifax | 17,407 | 1.00x | 17.9% | 13.6% | 0.76x |
| 4 | Verisk Analytics | 14,365 | 1.79x | 9.1% | 14.3% | 1.57x |
| 5 | Fleetcor Technologies | 13,885 | 1.25x | 13.0% | 24.1% | 1.86x |
| 6 | Iron Mountain | 9,207 | 3.23x | -4.4% | -25.9% | 5.92x |
| 7 | Broadridge Financial Soln | 9,014 | 1.01x | 7.2% | 8.8% | 1.23x |
| 8 | Deluxe | 3,441 | 0.86x | 4.1% | 6.6% | 1.63x |
| 9 | Ritchie Bros Auctioneers | 3,054 | 0.90x | -22.4% | -32.3% | 1.44x |
| 10 | WageWorks | 2,485 | 0.61x | -18.0% | -12.5% | 0.69x |
| 11 | ABM Industries | 2,473 | 0.28x | -25.7% | -24.4% | 0.95x |
| 12 | WNS (Holdings) | 1,753 | 0.28x | -35.3% | -35.9% | 1.02x |
| 13 | Insperity | 1,534 | 1.72x | 61.8% | 96.2% | 1.56x |
| 14 | Multi-Color | 1,357 | 1.27x | 17.5% | 26.7% | 1.52x |
| 15 | Viad | 1,002 | 0.70x | 66.9% | 58.3% | 0.87x |
source: ycharts
- Iron Mountain has one of the highest leverage in this sector (~3.23x) and it also has a pretty high degree of Leverage of 5.92x
- On the other hand, Automatic Data processing has a leverage of 0.50x and its degree of leverage is lower at 0.74x
To learn the nuts and bolts of Ratio Analysis, do have a look at this Complete Guide to Ratio Analysis
Conclusion
As we have seen from the article financial, leverage is a two-edged sword, which on one hand, magnifies the profit of the firm while on the other hand, can also increase the potential for loss. Therefore, the type of industry and the state of the economy, in which a company operates, are two very important factors to be considered before concluding the most appropriate amount of leverage.
Financial leverage Video
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This has been a guide to what is Financial Leverage, formula, and its calculation. Here we also take the degree of financial leverage examples of companies like Accenture, Nestle, Marriot and also sectors including Technology, Telecom, and Utilities.
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