We often talk about leverage in
our day to day life but what exactly is leverage. Lets try to understand it in
most simple words. The first step to success is keeping the basics clear and
Financiation pay a great weightage to the same.
As far as dictionary meaning is
concerned, leverage means positional advantage or power to act effectively. Now
what about financial meaning of leverage .All of us from finance industry or
finance education background or any businessman or investor and others must
have been using the word leverage day in and day out but what is exact
definition of leverage, also we talk about Operating leverage, Financial
leverage, Accounting leverage, Investing
leverage but what does these mean and its significance in a businessman, an analyst or in an investor life. Why a student
is being taught leverage & why do all of us know the meaning of leverage,
lets us try to understand all this. This post covers only the elementary topics
in leverage & advanced level to be covered in upcoming posts.
Leverage is most commonly defined
as debt or the degree to which business has borrowed funds. To some extent, it
is correct but is it only the business who borrow funds, investor too take an
extra privilege by investing through margins(in derivatives), also by investing
in fixed assets business entity is taking leverage over operational profit. So,
leverage in most simple words with respect to business entity can be defined as
use of fixed assets in company’s cost structure. For the purpose of
understanding the depth of leverage, this post covers leverage only from
business point of view.
Why would any firm make use of leverage(or we can say fixed costs- in the
form of more fixed assets-depreciation, rent(operating) or either in the form
of interest(financing)- The answer is very simple because it leads to
multiplication of profits. But again during downturn it can lead to multiplication
of losses also because it would take time for
a firm to reach at break even point . Also, its beneficial to borrow
funds from outside only when cost of borrowed funds is more than cost of equity
or in other words equity is giving higher returns than cost of borrowed
funds.High leverage means high risk, and with high risks their is always a possibility
of higher returns.
Any firm cost structure can be
divided into fixed costs(depreciation, rent, interest on debt etc) &
variable costs(cost of raw material purchased, freight charges, carriage charges etc). The firm
which has no fixed cost or minimal fixed cost will reach at its break even
point(no profit no loss situation) very soon as compared to the firm which has
incurred fixed cost because in first case, their is less of obligations by
firm. But, does that mean that firm with minimal fixed cost is better- certainly
no. Lets try to understand with an example-
|
Firm
A
|
Firm
B
|
Sales(Revenue
@Rs. 10 per unit for sales of 100000 units each)
|
1000000
|
1000000
|
Variable
Costs(production unit same as sale unit for both firm)
|
200000(Rs.
2 per unit)
|
600000(Rs.
6 per unit)
|
Fixed
Operating Cost
|
500000
|
150000
|
Fixed
financing Cost(Interest paid)
|
100000
|
50000
|
Net
Income(ignoring taxes)
|
200000
|
200000
|
Through the above mentioned
table, we can see that firm A is incurring more on fixed expense & Firm B
is incurring more on variable expense, but net income for both firms are same.
With increase in business operations, fixed cost will remain same but variable
cost will increase. Say the number of units produced increases to 2,00,000,in
such a scenario firm A will incur profit of Rs. 10,00,000/- & firm B will
incur profit of only Rs.6,00,000/-. Also, lets see a reverse that both firm
production reduces to 50,000 units. In such a scenario, firm A will incur loss
of Rs. 2 lacs & firm B will be at its break even, that is no profit no loss.
It means that firm A earnings are more volatile as compared to Firm B but at
the same time firm B has more capability of earning if there is an expansion phase
because higher risks always leads to the possibility of higher returns. So, the
optimal use of leverage can increase the earnings of the firm manifold. Also,
over leveraging can multiply losses. With respect to interest expenses, firm
can also enjoy tax benefits & thus provide the extra return to its
shareholders. But, borrowing from market is beneficial only when its cost if
less than the return on equity.
As illustrated above, leverage
leads to volatility in business. It is very important for an analyst to
understand company leverage because-
- Leverage increases volatility in earnings of the
company, its cash flow, and thereby impact its return & risk characteristics.
- It also helps in understanding the quality of
management decisions, & to know about the future prospects of business.
- It helps in valuation of any company, since
future cash flows & discount rates for finding their present value are very
much dependent on the degree of leverage of any firm
Thus leverage in its elementary
form can be defined as the use of fixed assets in the company’s cost structure
& degree of leverage measures how effectively the firm’s fixed cost has been
utilized to increase firm’s earnings.
Read more on Leverage in further posts.
