As the Degree of Financial Leverage Increases, What Happens?

Imagine you're on a thrilling roller coaster, the kind that slowly ticks its way up a steep incline before dropping you into a whirlwind of loops, twists, and turns. Now, replace that roller coaster with your company, and the steep incline? That's financial leverage. Financial leverage is the use of borrowed money (debt) to amplify potential returns to equity holders. As the degree of financial leverage (DFL) increases, so too does the risk and potential reward.

At first glance, increasing financial leverage might seem like an easy ticket to greater returns. After all, when you borrow money, you have more capital to invest, and if those investments pay off, the returns can be substantial. However, just like that roller coaster, the ride isn't without its perils. The more you borrow, the steeper the climb, and the more dramatic the fall if things don't go as planned.

So, what really happens as you crank up the degree of financial leverage? Let's explore this by first understanding how it works.

The Mechanics of Financial Leverage

At its core, financial leverage measures how much a company relies on debt to finance its operations. The formula for calculating the degree of financial leverage is straightforward:

$\text{Degree of Financial Leverage (DFL)}=\frac{\text{Percentage Change in EPS}}{\text{Percentage Change in EBIT}}$Degree of Financial Leverage (DFL)=Percentage Change in EBITPercentage Change in EPS​

Where:

• EPS stands for Earnings Per Share.
• EBIT stands for Earnings Before Interest and Taxes.

In simple terms, the DFL indicates how sensitive the company's EPS is to changes in its EBIT. A higher DFL means that a small change in EBIT will result in a larger change in EPS, whether positive or negative.

The Rewards of Increased Financial Leverage

One of the main attractions of financial leverage is the potential to magnify returns on equity. When a company uses debt to finance its operations, it can invest more in its business than it could with equity alone. If these investments generate returns higher than the cost of the debt, shareholders can enjoy outsized gains.

Consider a company with $1 million in equity and no debt. If it generates $200,000 in EBIT, its return on equity (ROE) is 20%. Now, imagine that same company takes on $1 million in debt at an interest rate of 5%, increasing its total capital to $2 million. If it invests this capital and doubles its EBIT to $400,000, the interest expense would be $50,000, leaving $350,000 in earnings. The new ROE would be 35%, a significant increase from the previous 20%.

The Risks of Increased Financial Leverage

However, just as leverage can magnify gains, it can also amplify losses. If the investments financed by debt fail to generate returns greater than the cost of the debt, the company could find itself in a precarious position. Interest payments are mandatory, regardless of how well the company is performing. When EBIT declines, a high DFL can cause a sharp drop in EPS, leading to financial distress or even bankruptcy.

Using the previous example, if the company’s EBIT falls to $100,000, the interest expense would still be $50,000, leaving only $50,000 in earnings. The new ROE would plummet to 5%, a dramatic fall from the initial 20%.

Case Study: Lehman Brothers

The collapse of Lehman Brothers in 2008 is a prime example of the dangers of excessive financial leverage. Lehman Brothers had a leverage ratio of 30:1, meaning it had $30 of debt for every $1 of equity. This extreme level of leverage allowed the company to generate high returns during the housing boom. However, when the housing market crashed, Lehman's massive debt load became unsustainable, leading to its eventual bankruptcy.

The Relationship Between DFL and Company Size

Interestingly, the impact of financial leverage can vary depending on the size of the company. Smaller companies, with less access to capital markets, might rely more heavily on debt to finance their operations. This can make them more vulnerable to economic downturns, as they may not have the financial flexibility to weather a prolonged period of low earnings.

Larger companies, on the other hand, often have more diversified revenue streams and greater access to equity financing, which can mitigate the risks associated with high financial leverage. However, even large companies are not immune to the dangers of excessive leverage, as evidenced by the 2008 financial crisis.

How to Manage Financial Leverage

Given the potential risks, how should companies manage their financial leverage? The key is to strike a balance between debt and equity financing. While debt can be a powerful tool for enhancing returns, it should be used judiciously. Companies need to carefully assess their ability to service debt under various economic scenarios and avoid overleveraging.

One approach is to maintain a conservative DFL by limiting the amount of debt relative to equity. This can reduce the volatility of EPS and provide a cushion in times of economic uncertainty. Another strategy is to match the maturity of debt with the expected cash flows from investments, ensuring that the company can meet its debt obligations without straining its finances.

The Role of Interest Rates

Interest rates play a crucial role in determining the cost of debt and, by extension, the degree of financial leverage. In a low-interest-rate environment, borrowing is relatively cheap, which can encourage companies to take on more debt. However, when interest rates rise, the cost of servicing debt increases, which can squeeze profit margins and reduce the benefits of leverage.

The Bottom Line: A Double-Edged Sword

In conclusion, financial leverage is a double-edged sword. When used wisely, it can amplify returns and help companies grow. However, excessive leverage can lead to financial distress and, in extreme cases, bankruptcy. Companies must carefully weigh the potential rewards against the risks and manage their leverage accordingly.

As an investor, understanding a company's degree of financial leverage can provide valuable insights into its risk profile and potential for growth. While high leverage can indicate the potential for high returns, it also signals greater risk. As the degree of financial leverage increases, so too does the importance of prudent risk management.