Trading on Equity, also known as Financial Leverage, is the balance between the cost financing operations with equity or debt and the income earned from the operations. In other words, it’s a gamble. The company is betting that the return from the investment will generate more income than it costs to finance the investment. Financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments.
Trading on equity occurs when a company incurs new debt (such as from bonds, loans, or preferred stock) to acquire assets on which it can earn a return greater than the interest cost of the debt. If a company generates a profit through this financing technique, its shareholders earn a greater return on their investments. In this case, trading on equity is successful. If the company earns less from the acquired assets than the cost of the debt, its shareholders earn a reduced return because of this activity. Many companies use trading on equity rather than acquiring more equity capital, in an attempt to improve their earnings per share.
Trading on equity has two primary advantages:
- Enhanced earnings. It may allow an entity to earn a disproportionate amount on its assets.
- Favorable tax treatment. In many tax jurisdictions, interest expense is tax deductible, which reduces its net cost to the borrower.
Below are two examples to illustrate the use of financial leverage, or simply leverage :-
Ram uses Rs.400,000 of his cash to purchase 40 acres of land with a total cost of Rs.400,000. Mary is not using financial leverage.
Ramesh uses Rs.400,000 of his cash and borrows Rs.800,000 to purchase 120 acres of land having a total cost of Rs.1,200,000. Ramesh is using financial leverage. He is controlling Rs.1,200,000 of land with only Rs.400,000 of her own money.
If the properties owned by Ram and Ramesh increase in value by 25% and are then sold, Ram will have a Rs.100,000 gain on his Rs.400,000 investment, a 25% return. Ramesh’s land will sell for Rs.1,500,000 and will result in a gain of Rs.300,000. Ramesh’s Rs.300,000 gain on his Rs.400,000 investment results in Ramesh having a 75% return. When assets increase in value leverage works well.
When assets decline in value the use of leverage works against you. Let’s assume that the properties owned by Ram and Ramesh decrease in value by 10% from their cost and are then sold. Ram will have a loss of Rs.40,000 on his Rs.400,000 investment—a loss of 10% on Ram’s investment. Ramesh will have a loss of Rs.120,000 (Rs.1,200,000 X 10%) on his Rs.400,000 investment. This is a loss of 30% (Rs.120,000 divided by Rs.400,000) on Ramesh’s investment.
How Financial Leverage Works
When purchasing assets, three options are available to the company for obtaining financing: using equity, debt, and leases. Apart from equity, the rest of the options incur fixed costs that are lower than the income that the company expects to earn from the asset. In this case, we assume that the company uses debt to finance the asset acquisition.
Financial Leverage Calculation
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.
A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.
The most well known financial leverage ratio is the debt-to-equity ratio. It is expressed as:
D/E Ratio = Total Debt / Total Equity
For example, Macy’s has $15.53 billion in debt and $4.32 billion in equity, as of fiscal year ended 2017. The company’s debt-to-equity ratio is $15.53 billion / $4.32 billion = 3.59. Macy’s liabilities are 359% of shareholders’ equity which is very high for a retail company.
Degree of Financial Leverage
Degree of financial leverage (DFL) is a ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. It measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT), and is represented as follows:
DFL can also be represented by the equation below:
Oil & Gas Companies Financial Leverage Example
Below is the graph of Exxon, Royal Dutch, BP and Chevron:-
Leverage of Oil and Gas Sector, in general, has increased. It all started primarily since 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.
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:-
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)
Risks of Financial Leverage
Although financial leverage may result in enhanced earnings for a company, it is also likely to result in disproportionate losses. Losses may occur when the interest expense payments for the asset overwhelm the borrower because the returns from the asset are not sufficient. It may occur when the asset declines in value or interest rates rise to unmanageable levels.
As we have seen from the article financial, leverage is a two edged sword, which on 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.