financial leverage:complete concept
TRANSCRIPT
Give me a lever long enough and a place to stand &I will move the entire earth. -Archimedes
Presented by:Ashutosh Mishra
Leverage
The amount of debt used to finance a firm's assets.
A firm with significantly more debt than equity is considered to be highly leveraged.
Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations.
Equity
The difference between the market value of a property & the claims held against it .
Financial leverage is the degree to which a business is utilizing borrowed money rather then equity to fund it’s operations.
It reflects the amount of debt used in the capital structure of the firm.
Financial Leverage
Return on assets (ROA)Return on equity (ROE) Earnings before interest and taxes(EBIT)Earnings per share(EPS)
Leverage allows greater
potential returns to the investor than otherwise would have been available but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.
Consider the rate of interest paid as fulcrum used in applying forces
through leverage.
Then we can arrive at following conclusions:Lower the interest rate, greater will be the profit.Less the chance of loss, less the amount borrowed, the lower will be the profit or loss.
Degree of financial leverage is defined as %
change in EPS that results from given % change in EBIT.
The calculation is likewise:FinLev =(%change in EPS):(%change in EBIT)
Measures of Financial Leverage
Debt-to-equity ratio = D/E
Debt ratio = D/(D+E)=D/V
Interest Coverage = EBIT/Interest
Leverage analysis of L & T Ltd.
It is a multi-product company in pvt. sector.Gross sales of company = Rs.8078.46crNet profit for year ending 31-mar-02 = Rs.346.80cr
Net worth 2696.22
Borrowings 1324.31
Profit before interest & tax(PBIT)
1088.78
Interest(paid) 92.09
Fixed expenses(excluding interest)
1583.30
* Data is Rs. In Crores
Debt-equity ratio = 1324.31/2696.22=0.49Debt-to- capital ratio = 1324.31/(2696.22+1324.31)=0.33Interest coverage = 1088.78/92.09=11.82Degree of financial leverage = 1.09 (moderate)
Formulae:
EPS=profit after tax or net income/no. of shares
ROE=profit after tax/value of equity
Use of the Du Pont Identity requires that leverage be measured in
terms of total assets divided by shareholders' equity, and this is sometimes referred to as gearing or simply leverage:
Leverage (gearing) = A / E
Real Time Data for Indian Companies (‘04)
Company Capital gearing Income gearing
Debt ratio Debt equity ratio
Interest coverage
Interest to EBIT ratio
Indian oil 0.346 0.530 23.6 0.042
Tata motors 0.261 0.353 16.7 0.060
Reliance 0.398 0.660 5.4 0.186
HLL 0.441 0.797 35.1 0.029
ONGC 0.022 0.022 331.00 0.003
There are 4 positions which show a relationship with the level of
financial leverage. First, is the relation of equity and debt, for
instance, the rate of capital. Second is the influences on business
production and cycle of financial leverage. Thirdly the company's
industry and branch whole financial leverage level. And also the correlation between the current financial leverage ratio of the
company and the middle leverage level. Lastly, the conformity of
company's mission and philosophy with the situation connected to the relation of financial leverage.
Levels of financial leverage
†Cash flow information is relevant for company’s ability to meet fixed financial obligations & not reported earnings.
†Future risk of company isn’t determined.
†It is only a measure of short term liquidity rather than leverage.