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Financial Leverage:complete concept

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Financial Leverage: for MBA first year.

Financial Leverage: for MBA first year.

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  • 1. Give me a lever long enough and a place to stand &
    I will move the entire earth. -Archimedes
    Presented by:
    Ashutosh Mishra
  • 2. 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.
    The difference between the market value of a property & the claims held against it .
    Equity
  • 3. Financial Leverage
    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.
    Return on assets (ROA)
    Return on equity (ROE)
    Earnings before interest and taxes(EBIT)
    Earnings per share(EPS)
  • 4. 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.
  • 5. 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.
    • 6. 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)
  • 7. 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.8078.46cr
    Net profit for year ending 31-mar-02 = Rs.346.80cr
  • 8. * Data is Rs. In Crores
    Debt-equity ratio = 1324.31/2696.22=0.49
    Debt-to- capital ratio = 1324.31/(2696.22+1324.31)=0.33
    Interest coverage = 1088.78/92.09=11.82
    Degree of financial leverage = 1.09 (moderate)
  • 9. 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
  • 10. Real Time Data for Indian Companies (‘04)
  • 11. Levels of financial leverage
    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.
  • 12.
  • 13.
    • Cash flow information is relevant for company’s ability to meet fixed financial obligations & not reported earnings.
    • 14. Future risk of company isn’t determined.
    • 15. It is only a measure of short term liquidity rather than leverage.
  • References
    • Financial Management by I M Pandey, 9th edition.
    • 16. The Internet.