Leverage analysis

What Is Leverage Analysis?

Leverage analysis is a quantitative method used in financial management to evaluate how a company's use of fixed costs and borrowed capital influences its profitability and risk profile. This analytical approach helps businesses understand the amplification effect that different financing and operational structures have on their earnings. By examining the relationship between sales volume, operational expenses, and financing costs, leverage analysis provides insights into a firm's inherent business and financial risks. There are typically three main types of leverage examined: operating leverage, financial leverage, and combined leverage⁴⁸.

History and Origin

The concept of leverage itself, referring to gaining disproportionate strength or output from a small input, dates back to ancient times with the invention of the physical lever⁴⁷. In finance, the application of leverage, particularly through the use of borrowed funds, has been a cornerstone for centuries, allowing entities to amplify investment capacity⁴⁵, ⁴⁶. The formal analysis of financial leverage in corporate settings evolved significantly over the 20th century. Historical data indicates a substantial increase in corporate leverage, with the aggregate debt-to-capital ratio of unregulated firms more than tripling between 1945 and 1970, and remaining elevated thereafter. This period saw debt increasingly substitute for other forms of capital, such as preferred equity⁴⁴. The systematic study of how fixed costs in operations and fixed financing costs impact a company's earnings and risk gained prominence as businesses grew in complexity and capital markets developed.

Key Takeaways

• Leverage analysis assesses the impact of fixed costs (operating and financial) on a company's earnings.
• It encompasses operating leverage, financial leverage, and combined leverage, each offering a distinct perspective on risk and return.
• High leverage can magnify both gains and losses, increasing the volatility of earnings per share.
• Companies utilize leverage analysis to optimize their capital structure and make informed decisions about debt and operational efficiency.
• Understanding leverage is crucial for investors and creditors to evaluate a company's solvency and risk exposure.

Formula and Calculation

Leverage analysis involves specific formulas for each type of leverage:

1. Degree of Operating Leverage (DOL)
The DOL measures the sensitivity of a company's operating income (EBIT - Earnings Before Interest and Taxes) to changes in sales. It indicates how fixed operating costs influence profitability⁴³.

Alternatively, it can be calculated using contribution margin and EBIT⁴²:

Where:

• Contribution Margin = Sales - Variable Costs
• EBIT = Sales - Variable Costs - Fixed Costs

2. Degree of Financial Leverage (DFL)
The DFL quantifies the impact of changes in EBIT on a company's earnings per share (EPS) or net income, driven by fixed financing costs like interest expense⁴⁰, ⁴¹.

Alternatively, it can be calculated as³⁹:

3. Degree of Combined Leverage (DCL)
The DCL measures the total risk arising from both operating and financial leverage, showing how a change in sales affects EPS³⁷, ³⁸.

Alternatively³⁶:

Interpreting Leverage Analysis

Interpreting the results of leverage analysis is key to understanding a company's risk and return characteristics. A high degree of operating leverage suggests that a significant portion of a company's costs are fixed; thus, small changes in sales can lead to larger fluctuations in operating income³⁵. This structure can lead to amplified profits during periods of rising sales but also magnified losses when sales decline.

Similarly, a high degree of financial leverage indicates a greater reliance on debt financing. While this can boost return on equity if the returns generated from borrowed funds exceed the interest expense, it also increases financial risk, including the potential for default³⁴. A company with high financial leverage will experience a more volatile EPS for a given change in operating income³³.

Combined leverage integrates these two aspects, providing a holistic view of how a company's entire cost structure—both operational and financial—influences its earnings per share in response to sales changes. A high combined leverage signifies that a small change in sales can result in a disproportionately large change in EPS, indicating higher overall business risk.

#³¹, ³²# Hypothetical Example

Consider "Alpha Manufacturing," a company that produces widgets.
In Year 1:

• Sales: 10,000 units @ $20/unit = $200,000
• Variable Costs: $8 per unit = $80,000
• Fixed Costs: $50,000
• Interest Expense: $10,000
• Number of Shares Outstanding: 5,000

Calculation for Year 1:

• Contribution Margin = $200,000 - $80,000 = $120,000
• EBIT = $120,000 - $50,000 = $70,000
• Earnings Before Tax (EBT) = $70,000 - $10,000 = $60,000
• Assume Tax Rate: 25% (Tax = $15,000)
• Net Income = $60,000 - $15,000 = $45,000
• EPS = $45,000 / 5,000 = $9.00

Now, let's say in Year 2, sales increase by 10% to 11,000 units ($220,000 revenue).

Calculation for Year 2 (with 10% sales increase):

• Sales: $220,000
• Variable Costs: 11,000 units @ $8/unit = $88,000
• Fixed Costs: $50,000 (remain constant)
• Interest Expense: $10,000 (remain constant)
• Contribution Margin = $220,000 - $88,000 = $132,000
• EBIT = $132,000 - $50,000 = $82,000
• EBT = $82,000 - $10,000 = $72,000
• Tax (25%) = $18,000
• Net Income = $72,000 - $18,000 = $54,000
• EPS = $54,000 / 5,000 = $10.80

Percentage changes:

• Change in Sales: (220,000 - 200,000) / 200,000 = 10%
• Change in EBIT: (82,000 - 70,000) / 70,000 = 17.14%
• Change in EPS: (10.80 - 9.00) / 9.00 = 20%

Degree of Operating Leverage (DOL):

Degree of Financial Leverage (DFL):

Degree of Combined Leverage (DCL):

In this example, a 10% increase in sales led to a 20% increase in EPS, demonstrating the amplifying effect of leverage. This shows how crucial understanding these ratios is for evaluating potential returns and risks.

Practical Applications

Leverage analysis is widely applied across various aspects of finance and business to inform strategic decisions.

• Corporate Strategy: Businesses use leverage analysis to design an optimal capital structure by balancing debt and equity financing. This helps in determining the appropriate mix to maximize shareholder wealth while managing financial risk management. Hi³⁰gh operating leverage might be suitable for companies with stable sales, while those with volatile demand might prefer lower fixed costs.
• Investment Decisions: Investors and analysts utilize leverage analysis to evaluate a company's financial health and potential for return on assets and return on equity. It helps in assessing how sensitive a company's earnings are to economic cycles or changes in sales, thus informing investment choices.
• ²⁹ Credit Analysis: Lenders and credit rating agencies rely on leverage ratios, such as the debt-to-equity ratio and debt-to-asset ratio, to gauge a borrower's ability to meet its debt obligations and the associated default risk. Th²⁷, ²⁸e level of debt on a company's balance sheet is a critical factor in assessing its creditworthiness.
• Regulatory Oversight: Regulatory bodies, such as the Federal Reserve, use leverage requirements as a component of bank capital regulations to ensure the stability of the financial system. Th²⁵, ²⁶ese requirements aim to limit excessive risk-taking by financial institutions. For instance, the Federal Reserve Board regularly assesses and revises capital requirements for large banks, including specific leverage requirements, to maintain financial stability.
• ²³, ²⁴ Macroeconomic Analysis: At a broader level, international organizations like the International Monetary Fund (IMF) monitor global debt levels, which are a form of leverage, to assess systemic financial risks and economic stability. The IMF's Global Debt Database provides comprehensive data on public and private debt, highlighting the widespread use and implications of leverage across economies.

#²⁰, ²¹, ²²# Limitations and Criticisms

While leverage analysis provides critical insights, it has limitations. A key criticism is that high leverage, while potentially amplifying gains, also magnifies losses during adverse economic conditions. Companies with high leverage may face significant financial distress or even bankruptcy if revenues decline or interest rates rise. Re¹⁸, ¹⁹search suggests that beyond a certain point, increasing financial leverage can have a negative impact on firm performance, particularly on measures like return on equity. Th¹⁶, ¹⁷is indicates that there isn't always a direct positive correlation between more debt and better performance, especially when considering factors like interest rates and the overall economic environment.

F¹⁴, ¹⁵urthermore, leverage ratios are often backward-looking, based on historical financial data. They may not fully capture the dynamic nature of a company's operations or unforeseen market shifts. The interpretation of leverage also needs to be contextualized within the specific industry; what is considered high leverage in one sector may be normal in another, depending on typical capital intensity and business models. Comparing leverage without considering these industry norms can lead to misleading conclusions.

Leverage Analysis vs. Financial Leverage

The terms "leverage analysis" and "financial leverage" are related but refer to different concepts.

⁵In essence, financial leverage is a component within the broader framework of leverage analysis. Leverage analysis provides a more holistic view of how a company's strategic decisions regarding its cost structure and financing mix influence its earnings and overall risk profile.

FAQs

What are the main types of leverage analyzed?

The three main types of leverage analyzed are operating leverage, financial leverage, and combined leverage. Operating leverage pertains to the use of fixed operating costs, financial leverage relates to fixed financing costs (debt), and combined leverage considers the joint effect of both.

##⁴# Why do companies use leverage?
Companies use leverage to amplify potential returns on their investments. By utilizing borrowed capital or a higher proportion of fixed costs, a company can potentially generate larger profits for its shareholders than it could with equity alone.

##³# How does leverage affect a company's risk?
Leverage significantly impacts a company's risk profile. While it can magnify profits during favorable conditions, it also amplifies losses during downturns. High operating leverage increases business risk, making profits more sensitive to sales fluctuations, while high financial leverage increases financial risk, raising the specter of default if debt obligations cannot be met.

##²# What is a good leverage ratio?
There isn't a universally "good" leverage ratio, as it varies significantly by industry, business model, and economic conditions. Companies in capital-intensive industries might naturally have higher operating leverage, while some sectors use more debt financing. Analysts typically compare a company's leverage ratios to its historical trends and industry averages to assess its financial health and risk.

##¹# How does leverage analysis inform the break-even point?
Operating leverage analysis is directly linked to the break-even point. A higher proportion of fixed costs (and thus higher operating leverage) means a company needs to achieve a higher sales volume to cover all its fixed and variable costs and reach its break-even point. Understanding this relationship helps management set pricing strategies and sales targets.