Degree financial leverage = Operating profit ÷ (Operating profit – Interest expense)
Financial leverage is simply the act of borrowing money to invest. This is done with the hope of earning a return on that money. A return that is greater than the cost. Often, the potential for gain is disproportionately bigger than the cost. But, the cost is fixed and will be the same regardless of the return earned. Small businesses must learn how to effectively manage their degree of financial leverage. Otherwise, they could find themselves buried under the weight of repayment.
Let’s talk about some of the advantages and disadvantages of financial leverage. Also, how the degree of financial leverage ratio can provide insight into net income.
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Financial leverage advantages
Financial leverage is a strategy that can be employed to boost gains. The cost of borrowed money (typically) doesn’t change. So, if that money can be used in a way that earns returns beyond the cost of borrowing – a small business can end up way better off than it would have otherwise.
I always say that every investment comes down to three things – cash in, cash out, and time. If the cost of leverage (cash out) is low enough and the terms are favorable (time), then the cash in has the best opportunity to be big enough to make financial leverage worthwhile.
High financial leverage helps small businesses avoid dilution of earnings from the issuance of equity. It also gives them the ability to put more money to work than they would have otherwise. Both of these advantages can translate into excess returns.
Additionally, interest is tax-deductible. This lessens the tax burden that a company would realize if the same funds were raised through equity. Keep in mind that interest is a fixed cost. A fixed cost that can negatively affect a small business if operating profits aren’t high enough.
Financial leverage is a better fit for some businesses than others
On my sister site, I’ve written often about the benefits of certain business models. For businesses with the right business model, more financial leverage could be very beneficial. This is if it brings in more long-term customers. These business models are conducive to earning a good ROI on borrowed money.
Handling debt responsibly = the ability to borrow more in the future
If a small business effectively employs financial leverage, their creditworthiness improves. With improved creditworthiness, they will (likely) be able to borrow more in the future. If they continue to execute effectively, they can earn compounded returns.
The cost of borrowing (rate) could drop with a successful history of repayment. This could decrease the cost of future financial leverage. Lower cost should mean lower risk. Lower risk increases the likelihood of employing it in a successful manner.
Financial leverage disadvantages
Just as it has the potential to boost gains, financial leverage can also boost losses. Every dollar borrowed represents a little more risk. Again, that’s why the return from the borrowed monies means so much.
But, the lender doesn’t care if your small business makes 10x the cost of borrowing. Or, if it “only” makes 100% of the cost of borrowing. It expects its money back, plus interest, either way.
Borrowing money will increase your cash flow out. If the cash flow in isn’t enough to offset that, then, sooner or later, insolvency will ensue.
It all depends on the context
A lot of the negative stigma surrounding borrowing stems from the personal sector. In the personal sector, when people borrow, they often do so to buy consumer goods. Things that don’t earn any sort of return. These items actually depreciate in value. For example, cars and technology.
Nobody flinches when somebody borrows an ungodly sum of money to buy a house. This is because a house (for better or worse) is expected to increase in value.
Just as certain business models are conducive to financial leverage, others are not. Consider business models that sell time for money or one-time purchase items. These businesses will have to be confident in their financial modeling to ensure that they can earn an adequate ROI on financial leverage.
Finally, the perception of leverage depends on timing. During boom times, the companies borrowing look like geniuses. Conversely, if the economy turns against a business that has irresponsibly borrowed, then they could look foolish.
Financial leverage + operating leverage?
There are two general types of leverage that a small business can use. Operational leverage (which I plan to write about next) and financial leverage. The degree of operating leverage measures the effect of fixed costs (not interest) on operating income.
Beware compounding leverage by adding operating (fixed costs) to financial, or vice versa. This could sneak up on a small business. It could create a situation where management is caught unprepared. The result is potentially catastrophic. It’s important that scenarios like this be modeled out and planned for.
Most people understand the risks associated with borrowing money (financial leverage). The risks of operating leverage are a little more camouflaged.
Make sure you plan around your company’s (potential) total leverage situation. Annual strategic planning with an operating budget allows you to do just that.
Regulatory authorities might paint an overly rosy picture
When interest rates are kept low, the hurdle rate (minimum ROI to justify investment) is also lower. This incentivizes small businesses to take on projects that they might not otherwise. Less is demanded of investments. The pursuit of extraordinary returns might stop short in favor of quick-and-easy (but “good enough”) returns.
Also, by making interest tax-deductible, the effective cost of leverage is lowered even further. This further incentivizes small businesses to use financial leverage. Doing so could amplify any of the previously mentioned disadvantages.
Financial leverage example
The Degree of Financial Leverage shows the amplification that borrowing money can provide to profits and losses. So, for instance, in the example operating budget, the Degree of Financial Leverage is 1.4. This means, at this level of borrowing, that for every 10% change in Operating Profit, Net profit would increase by 14% (10% × 1.4).
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That sounds great, but the opposite is also true. If Operating Profit declined by 10%, then this level of borrowing would cause Net profit to decrease by 14%. That’s the nature of leverage. It amplifies gains and losses.
I created a spreadsheet to model the changes in profit due to changes in other line items. It helps to better understand how the income statement is affected by financial leverage,
I started with a Base case income statement for a small business that has $1 million in sales. This example business also has a 20% operating margin with $500K in debt at a 5% Interest rate. Its Net profit is approximately $138K.
This company’s Degree of financial leverage is 1.14 ($200,000 ÷ [$200,000 – $25,000]).
Only one variable was changed at a time. Here’s what I found:
The effects of an increase or decrease in sales
A 10% increase in Sales translates into a 50% increase in Operating profit – all other things being equal. As expected, this 50% increase in Operating profit translates into a 57.1% increase in Net profit. This is because the Degree of financial leverage is 1.14 (50.0% × 1.14 = 57.1%).
The same thing happens, in the opposite direction. When Sales drop by 10%, Operating profit decreases by 50%. Net profit drops by 57.1%.
The effects of an increase or decrease in COGS and SG&A expenses
Since COGS is less than Sales, a 10% change doesn’t have as big of an effect on Operating profit. The result is a drop in Operating profit of 35%. As expected, the resulting change in Net profit is -40% (-35.0% × 1.14 = -40.0%).
SG&A expenses, being even lower, have less of an impact on Operating profit. A 10% increase only lowers Operating profit by 5% and Net profit by 5.7% (-5.0% × 1.14 = -5.7%).
Of course, things work the same in the opposite direction. A -10% change in COGS increases Operating profit by 35% and Net profit by 40%. A -10% change in SG&A expenses increases Operating profit by 5% and Net profit by 5.7%.
The effects of an increase or decrease in Long-term Debt & Interest rates
As shown above, changes in the income statement that result in increases to Operating profit are amplified in Net profit by the Degree of financial leverage.
But, what about changes below Operating profit? As expected, a 10% change in either the amount of LT Debt or the Interest rate, results in a corresponding 10% change in Interest expense.
This hypothetical small business carries a sizable amount of LT Debt. Still, Interest expense is still a relatively immaterial expense. Thus, the effect of a change in LT Debt and Interest rates is only ±1.4% on Net profit.
Going forward with a new Degree of financial leverage
Because of the nature of the Degree of financial leverage calculation (Operating profit ÷ [Operating profit – Interest expense]), when Operating profit increases, the Degree of financial leverage decreases – all other things being equal. The opposite is, of course, true too.
What does this mean?
It means that if your small business increases Operating profit this year, then your Degree of financial leverage is going to go down for next year. Which isn’t catastrophic. But, it means that a similar gain in Operating profit next year won’t translate into the same boost in Net profit.
To get that, your small business would have to borrow more funds.
On the same token, if your company has a decrease in Operating profit this year, then your Degree of financial leverage will increase for next year. This increase will amplify the effects of a gain in Operating profit next year. But, it doesn’t necessarily mean that you’ll end up ahead of where you would have been if you would have increased Operating profit in year 1.
Shortcomings of the Degree of financial leverage ratio
Again, the Degree of financial leverage ratio is calculated as follows:
Operating profit (EBIT) ÷ (Operating profit – Interest expense)
Big companies typically borrow money through the issuance of bonds. This means that they only pay interest until the bond matures.
Small businesses, like yours, don’t issue bonds. The nature of borrowing can vary, but often, loans are repaid on an installment basis. E.g. payments consist of both principal and interest.
So, a ratio that only measures the effects of Interest expense doesn’t completely capture the impact of financial leverage. For small businesses anyways.
Two extreme examples
First, consider a small business that borrowed 10x their previous year’s revenue. If they did so at a very low interest rate, their Degree of financial leverage would also be relatively low. But, having borrowed a disproportionate amount of money, they would theoretically have the opportunity to boost Sales/Operating profit greatly.
Also, consider the other extreme. What if a company borrowed a very modest amount of money? But, was forced to pay an exorbitant interest rate? In this instance, the Degree of financial leverage would be relatively high. But, the company’s opportunity to use this leverage in a beneficial manner is limited.
Finally, in order for the Degree of financial leverage to accurately predict the change in Net profit, Taxes must remain at a constant percentage. E.g. they can’t be 21% of Operating profit – Interest expense (EBT) one year and 22% the next. The Forecasted Change in Net profit won’t equal what’s calculated in the Confirmation.
The amount of LT Debt and the Interest rate/expense must also remain constant for the “Operating profit × Degree of financial leverage = Change in Net profit” equation to work out.
So, obviously, the Degree of financial leverage has limitations. It is designed for big businesses – not necessarily small ones. It is based on amounts in the income statement, and not the cash flow statement. Thus, no consideration is taken for the effects of principal repayment.
If its limitations are kept in mind, and if reasonable changes are forecasted, then it can provide guidance on the potential benefits or detriments of financial leverage.
How financial leverage affects business decisions
Plug your small business’ information into the Your degree of financial leverage worksheet. It will help you better understand how your borrowing might help or hinder you in the coming year.
Financial leverage, in and of itself, is neither good nor bad. It’s all about how it’s employed. If it’s used to buy (rather than sell) consumable assets that provide little or no return – it’s wasted. If it’s allocated to resources that increase productivity (or earn extraordinary returns) – it’s a valuable tool for small businesses.
What are your thoughts on the use of financial leverage?
What are some of the advantages and disadvantages I neglected to include?
How about some ways that you’ve effectively employed financial leverage in your small business?