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.

Pepsi-Financial-Leverage

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. read more increase dramatically? Is this good or bad for Pepsi?

Financial Leverage Formula

The formula of financial leverage with regards to a company’s capital structure can be written as follows:

Financial leverage Formula = Total Debt / Shareholder’s Equity

Please note that Total Debt = Short Term Debt + Long Term Debt.

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.read more

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.

Nestle Financial Leverage

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)2123021206
Total Shareholder’s Equity (2)62,33870,130
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.

Financial-Leverage-Oil-Gas-Companies

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?

Financial-Leverage-Marriott

source: ycharts

Did Marriott Raise Large Amounts of Debt?

Let us analyze this question by pulling out the relevant section of Marriott 2016 10K

Marriott Debt

source: Marriott International SEC Filings

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.read more 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.

Marriott Equity

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 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.read more (EBIT).

DFL can be calculated by using the formula given below:

Degree of Financial Leverage Formula = % change in EPS / % change in EBIT

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.

Accenture - Degree of Financial leverage 1

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.read more = % 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. NoNameMarket Cap  ($ mn)LeverageEBIT (YoY Growth)EPS ( YoY Growth) Leverage
1Dominion Energy48,3002.40x2.6%7.2%2.78x
2Exelon 48,1111.39x-29.4%-51.8%1.76x
3Dominion Energy 30,0662.40x2.6%7.2%2.78x
4Public Service Enterprise 22,1880.90x-46.8%-47.0%1.00x
5Avista 3,3841.12x14.4%9.1%0.63x
6Cosan  1,9142.94x-10.2%-35.4%3.48x

source: ycharts

Telecom Example

The below table provides data for Telecom companies along with other leverage details

S. NoNameMarket Cap  ($ mn)LeverageEBIT (YoY Growth)EPS ( YoY Growth)Degree of Financial Leverage
1America Movil 58,6133.41x-34.2%-78.8%2.30x
2Telefonica 54,8113.32x54.7%498.4%9.11x
3American Tower 58,0652.74x14.9%40.8%2.74x
4T-Mobile US 51,8241.52x84.1%106.0%1.26x
5BT Group 40,3711.50x-24.0%-41.6%1.73x
6Cable One  4,2931.18x16.4%13.3%0.81x
7Nortel Inversora4,4551.10x-21.6%-27.7%1.28x
8China Unicom35,2740.77x-76.4%-93.6%1.22x
9KT8,8480.71x21.2%26.4%1.24x
10Telecom Argentina 5,3560.62x-21.5%-27.2%1.26x
11Tim Participacoes  7,9310.40x-58.7%-66.0%1.12x
12Telekomunikasi Indonesia34,7810.33x21.8%25.3%1.16x
13ATN International 1,0660.24x-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. NoNameMarket Cap  ($ mn)LeverageEBIT (YoY Growth)EPS ( YoY Growth)Degree of Financial Leverage
1Alphabet 658,7170.03x22.5%22.5%1.00x
2NetEase 40,5450.10x63.9%63.0%0.99x
3SINA 6,6930.08x499.5%644.2%1.29x
4YY 4,0640.55x43.9%38.5%0.88x
5Web.com Group 1,1712.82x-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. NoNameMarket Cap  ($ mn)LeverageEBIT (YoY Growth)EPS ( YoY Growth)Degree of Financial Leverage Ratio
1Automatic Data Processing 46,1640.50x8.8%6.5%0.74x
2Fiserv26,8421.80x10.2%38.8%3.80x
3Equifax  17,4071.00x17.9%13.6%0.76x
4Verisk Analytics 14,3651.79x9.1%14.3%1.57x
5Fleetcor Technologies13,8851.25x13.0%24.1%1.86x
6Iron Mountain 9,2073.23x-4.4%-25.9%5.92x
7Broadridge Financial Soln 9,0141.01x7.2%8.8%1.23x
8Deluxe 3,4410.86x4.1%6.6%1.63x
9Ritchie Bros Auctioneers 3,0540.90x-22.4%-32.3%1.44x
10WageWorks 2,4850.61x-18.0%-12.5%0.69x
11ABM Industries 2,4730.28x-25.7%-24.4%0.95x
12WNS (Holdings) 1,7530.28x-35.3%-35.9%1.02x
13Insperity 1,5341.72x61.8%96.2%1.56x
14Multi-Color1,3571.27x17.5%26.7%1.52x
15Viad 1,0020.70x66.9%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 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.read more

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.