What is Financial Leverage and why is it called ‘Trading on Equity’? Explain the effect of Financial Leverage on EPS with the help of an example.

Q. What is Financial Leverage and why is it called ‘Trading on Equity’? Explain the effect of Financial Leverage on EPS with the help of an example.

Financial Leverage: An Overview

Financial leverage refers to the use of borrowed funds (debt) to finance the acquisition of assets, with the intention of increasing the potential return on equity (the funds invested by shareholders). The primary goal of using financial leverage is to magnify the returns generated by the business, which could result in higher profits for equity shareholders. However, while financial leverage can enhance returns during favorable conditions, it also introduces risk, as the business must meet its debt obligations irrespective of its profitability.

In simpler terms, financial leverage is about using debt to finance operations or investment projects. Companies borrow money to invest in assets or projects, and the goal is for these investments to generate returns that exceed the cost of borrowing, thereby increasing the value for shareholders.

Why is Financial Leverage Called ‘Trading on Equity’?

The term ‘Trading on Equity’ refers to the strategy of using debt to finance a company’s operations or investments, with the expectation that the return on investment will exceed the cost of debt. The term ‘equity’ here refers to the capital invested by the shareholders of the company, and ‘trading on equity’ essentially means that a company is using borrowed funds (debt) in conjunction with equity to amplify the returns to shareholders.

This concept is called ‘trading on equity’ because, when the return on assets financed by debt exceeds the cost of the debt, the equity holders (shareholders) benefit disproportionately. Essentially, the company is ‘trading’ on its ability to generate returns that are higher than the interest it needs to pay on borrowed funds, and thus, the equity portion becomes a tool to leverage the debt.

For example, if a company uses debt to finance a project that generates returns greater than the cost of the debt (interest), it is said to be "trading on equity." However, if the returns do not exceed the cost of debt, the company might incur losses, and this becomes risky. In this sense, trading on equity involves taking a calculated risk that the returns from the borrowed funds will exceed the obligations attached to them.

Effect of Financial Leverage on Earnings Per Share (EPS)

Earnings Per Share (EPS) is a critical financial metric that represents the portion of a company’s profit allocated to each outstanding share of common stock. EPS is an important measure of a company's profitability and is closely monitored by investors.

The formula for EPS is:

$\text{EPS} = \frac{\text{Net Income - Preferred Dividends}}{\text{Number of Outstanding Shares}}$

In the context of financial leverage, the use of debt can have a significant impact on the company’s EPS. The relationship between financial leverage and EPS is influenced by the company’s ability to earn a return on the funds borrowed that exceeds the cost of that debt.

When a company uses financial leverage (borrowing funds), it increases its total capital base. As long as the return on assets generated from this borrowed capital is higher than the interest on the debt, the company can increase its EPS because the profit generated by the debt (which is distributed among the existing equity holders) exceeds the cost of the debt.

However, if the return on investment is lower than the cost of debt, financial leverage can decrease EPS because the company is still obligated to pay interest, and the returns are not enough to cover the debt cost.

Positive Financial Leverage:

When the return on investment exceeds the cost of debt (i.e., the interest rate), financial leverage is said to be positive, and it increases the EPS. This is often referred to as a favorable trading on equity situation.

Negative Financial Leverage:

When the return on investment is less than the cost of debt, financial leverage is said to be negative, and it decreases the EPS. This scenario can be described as unfavorable trading on equity, where the company is not able to generate enough returns from borrowed capital to cover its debt obligations, thereby reducing profits available for shareholders.

Example: The Effect of Financial Leverage on EPS

Let’s consider a practical example to demonstrate how financial leverage can affect EPS:

Scenario:

Assume a company, ABC Ltd., has the following financial data for two different situations: one where it uses no debt (equity financing only) and one where it uses debt (financial leverage) to finance a new investment project.

1. No Debt Financing (Equity Financing Only):

o Net Income: ₹1,000,000

o Number of Outstanding Shares: 100,000

o Preferred Dividends: ₹0 (no preferred stock)

EPS (No Debt) = $\frac{\text{Net Income - Preferred Dividends}}{\text{Number of Outstanding Shares}}$

$\text{EPS} = \frac{1,000,000}{100,000} = ₹10 \text{ per share}$

2. Debt Financing (Financial Leverage): In this case, the company decides to borrow ₹5,000,000 at an interest rate of 10% to fund a new project. The project is expected to generate additional returns of ₹600,000 per year.

o Interest on Debt: ₹5,000,000 × 10% = ₹500,000

o Net Income (after interest): ₹1,000,000 + ₹600,000 (return on the project) - ₹500,000 (interest on debt) = ₹1,100,000

o Number of Outstanding Shares: 100,000 (no new shares issued)

EPS (With Debt) = $\frac{\text{Net Income - Preferred Dividends}}{\text{Number of Outstanding Shares}}$

$\text{EPS} = \frac{1,100,000}{100,000} = ₹11 \text{ per share}$

Analysis:

In this scenario, the company’s EPS increased from ₹10 per share to ₹11 per share after using financial leverage. The additional returns generated by the project exceeded the interest on the debt, resulting in a positive effect on the company’s EPS. This demonstrates how financial leverage, when used effectively, can amplify returns for shareholders.

Negative Financial Leverage Example:

Let’s consider a scenario where the project returns are less than the interest cost of debt.

Interest on Debt: ₹5,000,000 × 10% = ₹500,000
Return from the project: ₹400,000

Now, the net income after interest is:

$\text{Net Income} = ₹1,000,000 + ₹400,000 - ₹500,000 = ₹900,000$

EPS (With Debt) = $\frac{900,000}{100,000} = ₹9 \text{ per share}$

In this case, the company’s EPS decreased from ₹10 per share (in the no-debt scenario) to ₹9 per share after taking on debt. This illustrates negative financial leverage, where the cost of debt is higher than the returns from the investment, leading to a reduction in EPS.

Key Insights and Conclusion

1. The Role of Financial Leverage: Financial leverage can significantly impact EPS. If the return on investment exceeds the cost of borrowing, it can increase EPS, benefiting shareholders. However, if the cost of debt exceeds the return on investment, EPS will decrease, which can harm the financial position of the company.

2. Risk and Return: While financial leverage can enhance returns, it also increases the financial risk of the company. If the company cannot meet its debt obligations, it can face financial distress. Therefore, careful consideration must be given to the level of debt in a company’s capital structure.

3. Trading on Equity: The term ‘trading on equity’ captures the idea that a company is using borrowed funds to increase the returns to equity shareholders. The term is derived from the way the company "trades" on its ability to generate returns from debt financing to benefit equity holders.

4. Impact on Investor Decisions: Investors often monitor EPS to gauge the profitability of a company. A company using financial leverage effectively can present a higher EPS, which might attract investors. Conversely, poor use of financial leverage can lead to lower EPS, potentially deterring investors.

In conclusion, financial leverage is a powerful tool in corporate finance that can influence EPS either positively or negatively, depending on how effectively the borrowed funds are deployed. Companies must carefully assess their use of debt, balancing the potential benefits of trading on equity with the risks associated with increased leverage.