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 and its Role in Trading on Equity
Introduction:
Financial leverage refers to the use of borrowed funds
to amplify the potential returns on investment. In the context of a business or
corporation, it represents the ratio of debt used in the capital structure
relative to equity. Financial leverage can enhance returns when the return on
investment (ROI) exceeds the cost of debt. However, it can also magnify losses
if the ROI falls short of the cost of debt. The term "Trading on
Equity" is often used in conjunction with financial leverage because it
highlights how equity holders benefit from using borrowed funds. When a company
uses leverage effectively, it can increase the return on equity (ROE), but it
comes with the added risk of amplified losses if the company does not generate
sufficient earnings to cover the debt obligations.
This in-depth discussion explores the concept of
financial leverage, its impact on Earnings Per Share (EPS), and the phenomenon
known as "Trading on Equity." We will delve into how the relationship
between debt and equity can significantly influence a company’s financial
performance, and we will illustrate this with the help of a detailed example.
Financial leverage refers to the practice of using
debt to acquire additional assets in order to increase the potential return on
equity. Leverage allows companies to use borrowed capital (debt) to finance
their operations or investments, instead of solely relying on their own capital
(equity). The use of financial leverage is common in corporate finance, and it
is an essential component of a company’s capital structure. A company’s
leverage is usually measured by the debt-to-equity ratio, which compares the
total debt to the total equity in the capital structure.
In simpler terms, financial leverage is the
magnification of both potential gains and potential losses, depending on the
company’s ability to generate returns on the borrowed capital. When a company
borrows money, it is required to repay the debt along with interest. If the
return generated by the borrowed funds is greater than the cost of the debt
(interest rate), the shareholders or equity holders will benefit, as the
company’s return on equity (ROE) will increase. Conversely, if the return
generated is lower than the cost of the debt, the shareholders face a risk of
reduced returns or even losses.
Why is Financial Leverage Called ‘Trading on Equity’?
The term "Trading on Equity" refers to the
practice of using borrowed funds (debt) to invest in assets or operations,
which can enhance the returns to equity shareholders. The concept is often
associated with financial leverage because it highlights the fact that equity
holders are benefiting from the firm’s use of debt. When a company takes on
debt, it increases its total capital, and if the return on the investments
funded by this capital exceeds the cost of debt, the equity holders enjoy
higher profits. This phenomenon is often called "Trading on Equity"
because the equity capital is "traded" or magnified through the use
of debt.
Essentially, trading on equity involves using debt to
increase the potential return on equity. If the company’s operations or
investments generate returns greater than the interest rate on the borrowed
funds, the equity holders benefit from the higher returns generated by the
leverage. However, if the returns fall short of the debt obligations, the
equity holders bear the downside risk. Therefore, while trading on equity can
increase the rewards, it also magnifies the risks for the equity holders.
How Financial Leverage Affects Earnings Per Share
(EPS)
Earnings Per Share (EPS) is one of the most critical
indicators of a company's profitability, as it shows how much profit the
company has earned for each share of common stock outstanding. Financial
leverage can have a significant impact on EPS, as it affects both the numerator
(earnings) and the denominator (number of shares) of the EPS formula. When a
company uses debt to finance its operations, it incurs interest expenses, which
are deducted from the earnings before tax (EBT). This affects the net income of
the company and ultimately impacts the EPS.
The impact of financial leverage on EPS can be
understood through the following formula:
Let’s break down
how leverage affects both the numerator and the denominator:
1. Impact on Earnings
(Numerator): When a company uses
debt financing, it must pay interest on the debt, which reduces the earnings
available to equity holders (i.e., net income). However, if the return on the
borrowed capital exceeds the cost of debt (interest), it can increase the
overall earnings of the company, which may result in higher EPS for
shareholders.
2. Impact on Shares
Outstanding (Denominator):
Financial leverage does not directly affect the number of shares outstanding
unless the company issues additional shares to raise capital for debt servicing
or other purposes. However, in most cases, the impact of leverage is felt
through changes in the company’s profitability rather than changes in the share
count.
Example of Financial Leverage Impact on EPS:
To better understand how financial leverage affects
EPS, let’s look at a detailed example involving two companies with different
levels of debt.
Scenario:
·
Company A (No Debt):
- Earnings
Before Interest and Tax (EBIT): ₹10,00,000
- Interest
Expense: ₹0
- Number of
Outstanding Shares: 100,000
- Tax Rate:
30%
·
Company B (With Debt):
- Earnings
Before Interest and Tax (EBIT): ₹10,00,000
- Interest
Expense: ₹2,00,000
- Number of
Outstanding Shares: 100,000
- Tax Rate:
30%
Let’s calculate the EPS for both companies.
1. EPS Calculation
for Company A (No Debt):
For Company A, since there is no interest expense, the
EBIT is equal to the earnings before tax (EBT).
Now, we calculate
the net income:
Finally, we
calculate the EPS for Company A:
2. EPS
Calculation for Company B (With Debt):
For Company B, we have to account for the interest
expense of ₹2,00,000, which reduces the earnings before tax (EBT).
Now, we calculate
the net income for Company B:
Finally, we
calculate the EPS for Company B:
Comparison:
Company |
EBIT (₹) |
Interest Expense (₹) |
EBT (₹) |
Net Income (₹) |
EPS (₹ per Share) |
Company A |
₹10,00,000 |
₹0 |
₹10,00,000 |
₹7,00,000 |
₹7.00 |
Company B |
₹10,00,000 |
₹2,00,000 |
₹8,00,000 |
₹5,60,000 |
₹5.60 |
From this example, we can see that the EPS of Company
B is lower than that of Company A due to the interest expense associated with
the debt financing. While both companies generated the same EBIT, the interest
expense in Company B reduced the earnings available to equity holders,
resulting in a lower EPS for Company B.
Impact
of Financial Leverage on EPS:
·
Positive Impact: If Company B had generated returns on its borrowed
funds that exceeded the interest expense (e.g., if it invested the debt in
high-return projects), the impact on EPS could have been positive. The extra
earnings generated from the debt would have increased the net income, and as a
result, the EPS would have been higher.
·
Negative Impact: If the returns on the borrowed funds do not exceed
the cost of debt, as in the example above, the use of leverage will reduce the
company’s net income and thus lower the EPS.
Conclusion:
Financial leverage, when used wisely, can amplify
returns for equity holders, leading to higher earnings per share (EPS).
However, if the returns on borrowed funds do not surpass the interest costs,
the effect can be detrimental, reducing the overall profitability and lowering
the EPS. This phenomenon is known as "Trading on Equity" because the
company is leveraging its equity to increase returns by taking on debt.
Companies must carefully manage their capital structure and assess the risk and
reward of using financial leverage, as it can significantly impact shareholder
wealth and company performance. Understanding the balance between risk and
reward is crucial for any firm when deciding how much debt to use in its
capital structure.
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