How do small businesses choose their capital structure? When is it appropriate for a small business to finance its operations with borrowed funds? What is the nature and role of effective leverage in financial management? These questions relate to the optimal capital structure of a business firm: the right mix of debt and equity that maximizes return on investment and shareholder wealth while minimizing the cost of capital. Clearly, effective leverage is vital to a sound business strategy designed to maximize the wealth-producing capacity of the company. In this series on effective financial management, we will focus on relevant strategic financing issues and provide some guidance. The main purpose of this article is to highlight some basic financial theories and industry practices on effective financial leverage. For specific financial management strategies, consult a competent professional.
Keep in mind that the appropriate amount of financial leverage for each company differs markedly depending on the overall dynamics of the industry, the level of competition in the market structure, the stage of the industry life cycle, and its competitive position in the market. In fact, as with most market indicators, company-specific leverage position is revealing only in reference to expected industry value (average) and generally accepted industry benchmarks and best practices. .
Leverage Types:
Financial Leverage: The degree of financial leverage is the ratio of EBIT/EBT earnings before interest and taxes divided by earnings before taxes. When a business relies on borrowed funds for its operations, financial leverage is created when the business incurs fixed financial obligations or interest on the borrowed funds. A given percentage change in the company’s operating income (EBIT) produces a larger percentage change in the company’s net income (NI) and earnings per share. In fact, a small percentage change in operating income (EBIT) is magnified into a larger percentage reduction in net income. The degree of financial leverage (DFL) measures a company’s exposure to financial risk or the sensitivity of earnings per share (EPS) to changes in EBIT. Therefore, DFL indicates the percentage change in earnings per share (EPS) that emanates from a unit percentage change in earnings before interest and taxes (EBIT). In general, a company’s short-term financing needs are influenced by current sales growth and how effectively and efficiently the company manages its net working capital: current assets minus current liabilities. Keep in mind that ongoing short-term financing needs may reflect an ongoing long-term financing need, including an assessment of the appropriate mix and use of debt and equity – the capital structure.
Operating Leverage: Fixed operating costs such as general overhead, contract employee salaries, and mortgage or lease payments create operating leverage and tend to raise business risk. The impact of operating leverage is evident when a given percentage change in net sales results in a larger percentage change in operating income (EBIT)-earnings before interest and taxes. Operating leverage is calculated as follows: DOL = CM/EBIT-contribution margin divided by earnings before interest and taxes or the percentage change in EBIT divided by the percentage change in sales (revenue).
Combined Leverage: The Degree of Combined Leverage (DCL) is the combination of the effects of business risk and financial risk. The degree of operating leverage (DOL) and the degree of financial leverage (DFL) combine to magnify a given percentage change in sales to a potentially much larger percentage change in earnings or operating income (EBIT). There is a direct relationship between the degrees of operating leverage (DOL), financial leverage (DFL) and combined leverage (DCL). The degree of combined leverage (DCL) of a company = DOL X DFL or CM/EBIT X EBIT/EBT which is CM/EBT. The degree of combined leverage (DCL) can also be calculated as the percentage change in EPS divided by the percentage change in sales, which is the percentage change in earnings per share that emanates from a unit percentage change in sales volume.
Optimal Capital Structure: This is the appropriate use of debt and equity that minimizes the company’s cost of capital and maximizes its stock price. Note that a non-optimal capital structure or lack of an optimal mix of debt and equity can lead to higher financing costs and the company may reject some capital budgeting projects that would have increased shareholder wealth with a financing. optimum. Additionally, the effects of different capital structures and different degrees of business risk are reflected in a company’s income statement. Note that operating leverage tends to magnify the effect of fluctuating sales (revenue) and produces a percentage change in operating income (EBIT) greater than the change in sales (revenue), while financial leverage tends to magnify percentage change in EBIT and produces a larger percentage change in EPS. Therefore, a change in sales (revenue) through operating leverage affects EBIT. This change in EBIT due to the effect of financial leverage subsequently affects EPS.
Some helpful guidelines:
When a company grows, it needs capital that can be financed with equity or debt. Debt financing has costs and benefits. Debt has two significant benefits: the interest paid is tax deductible, minimizing the effective cost of debt; and debt carries a fixed charge, so shareholders don’t have to share in their net income if the company is extremely profitable. On the other hand, a high debt ratio indicates a higher risk and, therefore, a higher cost of capital; and if the business does not earn enough revenue to cover its fixed charges, it must go into deficit or face bankruptcy. Therefore, companies with volatile operating earnings and cash flows should limit their use of debt financing. Indeed, effective cash flow and leverage management is essential to a sound and prudent strategy designed to maximize the company’s wealth-producing capacity. In addition, the strategic analysis, the market analysis and the financial analysis must be internally consistent and consistent. EBIT/EPS analysis allows a company to assess the effects of different capital structures on operating income and the level of business risk. The variability of sales or revenues over time is a basic operating risk. Note that in the capital budget for a specific project to increase shareholder wealth, you must earn more than your cost of capital or hurdle rate.
In practice, companies tend to use a target capital structure: a combination of debt, preferred stock, and common equity with which the company plans to raise the necessary funds. And because capital structure policy implies a strategic trade-off between risk and expected return, the optimal capital structure policy must strike a prudent and informed balance between risk and return. The company must consider its business risk, fiscal position, financial flexibility, and managerial conservatism or aggressiveness. While these factors are crucial in determining the target capital structure, operating conditions can cause the actual capital structure to differ materially from the optimal capital structure. Therefore, the target capital structure should be used as a guide to an ideal capital structure that minimizes the weighted average cost of capital (WACC) while maximizing shareholder wealth.
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