What is leverage/ gearing ?

Leverage is a firm’s ability to use its fixed cost assets or funds to magnify the returns to its owners. There exists 2 types of fixed cost in the firm’s capital structure 1. Operating fixed cost ( Fixed house rent, fixed salary of employees, marketing, selling, promotion and advertising expense).  2. Financial Fixed cost (interest of debt, fixed dividend of preferred stock).

By proper utilizing of operating fixed cost, firm can increase its earnings. These expense creates operating leverage. If earnings are more than its expense, it is called favorable leverage, if the earnings are less than its expense, it is called unfavorable expense.

By proper utilizing of financial fixed cost, a firm creates financial leverage.

Operating leverage is shown on the top half of the income statement and financial leverage is shown on the bottom half of the income statement which shows how earnings per share changes in response to changes in EBIT.  

What are leverage ratios?

A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement.  These ratios provide an indication of how the company’s assets and business operations are financed (using debt or equity). Below is an illustration of two common leverage ratios: debt/equity and debt/capital.

List of common leverage ratios

There are several different leverage ratios that may be considered by market analysts, investors, or lenders. Some accounts that are considered to have significant comparability to debt are total assets, total equity, operating expenses, and incomes.

Below are 5 of the most commonly used leverage ratios:

1.     Debt-to-Assets Ratio = Total Debt / Total Assets

2.     Debt-to-Equity Ratio = Total Debt / Total Equity

3.     Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)

4.     Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)

5.     Asset-to-Equity Ratio = Total Assets / Total Equity

Leverage ratio example #1

Imagine a business with the following financial information:

• $50 million of assets
• $20 million of debt
• $25 million of equity
• $5 million of annual EBITDA
• $2 million of annual depreciation expense

Now calculate each of the 5 ratios outlined above as follows:

1.     Debt/Assets = $20 / $50 = 0.40x

2.     Debt/Equity = $20 / $25 = 0.80x

3.     Debt/Capital = $20 / ($20 + $25) = 0.44x

4.     Debt/EBITDA = $20 / $5 = 4.00x

5.     Asset/Equity = $50 / $25 = 2.00x

Leverage Ratio in the credit boom and bust

In the financial boom years of 2000-2007, banks increased their leverage. Leverage ratios fell as they decreased the capital buffer they had. The motive for increasing lending was that they were trying to increase profitability. Also, banks had little concern about going bankrupt because there is an implicit guarantee that the government will bail out banks.

Regulation on Bank leverage

Leverage ratio requirements in different countries. There is a global base leverage requirement of 3%, set in Basel III. But, other countries may have higher leverage requirements.

·         Under federal bank regulations, a US bank must have Tier 1 Capital ratio of at least 4%. The US is also considering raising the leverage ratio to 5%.

Below are two examples to illustrate the use of financial leverage, or simply leverage.

Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of $400,000. Mary is not using financial leverage.

Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money.

If the properties owned by Mary and Sue increase in value by 25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a 25% return. Sue's land will sell for $1,500,000 and will result in a gain of $300,000. Sue's $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well.

When assets decline in value the use of leverage works against you. Let's assume that the properties owned by Mary and Sue decrease in value by 10% from their cost and are then sold.Mary will have a loss of $40,000 on her $400,000 investment—a loss of 10% on Mary's investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue's investment.

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WHY IT MATTERS:

Too much leverage can be bad, but there's no hard and fast rule as to how much is too much. No matter what its use, leverage can be a powerful tool when used responsibly.

For investors considering companies with debt, one of the most popular evaluations of a company's leverage is the debt-to-equity ratio (D/E). The interest coverage ratio, also known as times interest earned, is also a measure of how well a company can meet its interest-payment obligations. In general, these ratios suggest whether a company is "too safe" and is neglecting opportunities to magnify earnings through leverage or is over leveraged and at serious risk of default or bankruptcy.