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.

EquityThe 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 2696.22Borrowings 1324.31

Profit before interest & tax(PBIT)

1088.78

Interest(paid) 92.09Fixed 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.

References

•Financial Management by I M Pandey, 9th edition.

•The Internet.