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 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.

What is Financial Leverage?

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:

$EPS = \frac{{\text{{Net Income}}}}{{\text{{Outstanding Shares}}}}$

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).

$EBT = EBIT = ₹10,00,000$

Now, we calculate the net income:

$\text{Net Income} = EBT \times (1 - \text{Tax Rate}) = ₹10,00,000 \times (1 - 0.30) = ₹10,00,000 \times 0.70 = ₹7,00,000$

Finally, we calculate the EPS for Company A:

$EPS = \frac{{\text{Net Income}}}{{\text{Shares Outstanding}}} = \frac{{₹7,00,000}}{{100,000}} = ₹7 \text{ per share}$

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).

$EBT = EBIT - \text{Interest Expense} = ₹10,00,000 - ₹2,00,000 = ₹8,00,000$

Now, we calculate the net income for Company B:

$\text{Net Income} = EBT \times (1 - \text{Tax Rate}) = ₹8,00,000 \times (1 - 0.30) = ₹8,00,000 \times 0.70 = ₹5,60,000$

Finally, we calculate the EPS for Company B:

$EPS = \frac{{\text{Net Income}}}{{\text{Shares Outstanding}}} = \frac{{₹5,60,000}}{{100,000}} = ₹5.60 \text{ per share}$

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.