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 RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. 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 operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation..
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 lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its 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 risksAnalyze Financial RisksFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy. 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 LeverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.
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 –
- Capitalization RatioCapitalization RatioCapitalization ratios are a set of ratios that assist analysts in determining how a company's capital structure will affect if an investment is made in the company. The debt-to-equity, long-term debt-to-market-cap, and total debt-to-market-cap ratios are all included.
- Capital GearingCapital GearingCapital Gearing, also called Financial Leverage, is the level of debt that a Company utilizes for obtaining assets. It is determined as the ratio of Total Equity to Total Debt.
- Defensive Interval RatioDefensive Interval RatioThe defensive interval ratio evaluates the number of days a company can function without utilizing its non-current assets or outside financial resources. The formula is "Defensive Interval Ratio (DIR) = Current Assets / Average Daily Expenditures."
Oil & Gas Companies Example (Exxon, Royal Dutch, BP & Chevron)
Below is the graph of Exxon, Royal Dutch, BP, and Chevron.
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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company..
Why Marriott International Financial Leverage Increased Drastically?
Why do you think Leverage has increased drastically?
Did Marriott Raise Large Amounts of Debt?
Let us analyze this question by pulling out the relevant section of Marriott 2016 10K
Marriott Current Portion of Long Term DebtCurrent Portion Of Long Term DebtCurrent Portion of Long-Term Debt (CPLTD) is payable within the next year from the date of the balance sheet, and are separated from the long-term debt as they are to be paid within next year using the company’s cash flows or by utilizing its current assets. 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 the snapshot below of Shareholder’s Equity of Marriott Internation.
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 taxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital. (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.
Let us look at Accenture example to get an understanding of the calculation of the Degree of Financial Leverage ratio. Below is the Income StatementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. of Accenture pulled from its SEC FilingsSEC FilingsSEC filings are formal documents submitted to the Securities and Exchange Commission in the United States that contain financial information about the company as well as any other relevant information about recent or upcoming activities..
source: Accenture SEC Filings
Degree of Financial Leverage FormulaDegree Of Financial Leverage FormulaThe degree of financial leverage formula computes the change in net income caused by a change in the company's earnings before interest and taxes. It aids in determining how sensitive the company's profit is to changes in capital structure. = % 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 the 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 $848,823 added after Operating Income (EBIT). This gain doesn’t occur in previous years.
- If we want to make an apple to apple comparison, we should have deducted this gain on Sale of Business and normalized the EPS. This normalized EPS should’ve been used for the Leverage Ratio calculations.
Please note that the Degree of Financial leverage ratio is thus extremely valuable for helping an organization assess the quantity of debt or leverage it ought to choose in its capital structure. If operating financial gain is comparatively stable, then earnings and EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. would be stable as well, and the company will be able to afford to take a large amount of debt. However, if the firm operates in a sector where operating financial gain is kind of volatile, it may be prudent to limit the debt to easily manageable levels.
Utilities Sector Example
The below table provides us with the list of top Utility companies along with their Market CapMarket CapMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share., Leverage, EBIT, and EPS Growth, and Degree of Financial Leverage.
|S. No||Name||Market Cap ($ mn)||Leverage||EBIT (YoY Growth)||EPS ( YoY Growth)||Leverage|
|4||Public Service Enterprise||22,188||0.90x||-46.8%||-47.0%||1.00x|
- 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 leverageDegree Of Operating LeverageThe Degree of Operating Leverage (DOL) of a company measures how a change in sales affects its operating income. A higher DOL indicates a higher proportion of fixed costs in business operations, whereas a lower DOL indicates a lower proportion of fixed costs in business operations. is 2.78x.
- The leverage of Public Service Enterprise is 0.90x (lower as compared to its peer group). Due to its lower leverage ratioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity., its leverage is at 1.0x.
The 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|
- Overall, the sector doesn’t have consistent leverage and degree of operating leverage across companies
- America Movil has high leverage of 3.41x, due to which it has 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
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|
- 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 lower leverage of 0.10x. Its ratio is 0.99x.
Business Services Example
The 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|
|7||Broadridge Financial Soln||9,014||1.01x||7.2%||8.8%||1.23x|
|9||Ritchie Bros Auctioneers||3,054||0.90x||-22.4%||-32.3%||1.44x|
- 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 FormulaRatio Analysis FormulaRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.
As we have seen from the article financial, leverage is a two-edged sword, which on the 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
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.