Financial Leverage

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 –

• Capitalization Ratio
• Capital Gearing
• Defensive Interval Ratio

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 the 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 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 EPS 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

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
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 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

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 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
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 Formula

Conclusion

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

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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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