Leverage can magnify earnings both up and down. The profits of highly leveraged firms might soar with small upturns in revenue
Enhancing shareholder value is one of the primary objectives of corporate executives. This could be done in many ways, such as improved sales, reduced costs of production and overheads, and so on. Yet another way of doing so is financial leverage, which involves adding a reasonable amount of debt to the capital structure to lift the company’s value.
Types of leverage
Leverage is a general term for the use of fixed costs in a company’s cost structure. There are two types of leverage: Operating fixed costs such as depreciation or rent create operating leverage; and financial fixed costs like interest expense create financial leverage.
The use of fixed costs acts as leverage because they act as a fulcrum for the company’s earnings. Leverage can magnify earnings both up and down. The profits of highly leveraged companies might soar with small upturns in revenue. But the reverse is also true, even small downturns in revenue may lead to magnified losses.
Why leverage enhances value
The rationale for adding debt to a company’s capital structure is to minimise the weighted average cost of capital (WACC) as per the proportion and cost of debt and equity capital. As tax laws allow a deduction on interest payments, WACC tends to be lower for more leveraged companies as long as they are able to service the debt. A lower WACC increases the calculated present value of anticipated future cash flow, which is projected to increase the share price.
Concerns about leverage
Most of us generally try to be careful on how much debt we take. The same goes for companies. Shareholders need to understand a company’s use of leverage for three main reasons. First, the degree of leverage is an important component in assessing a company’s risk and return characteristics. Second, investors may be able to discern information about a company’s business and future prospects from management’s decisions about the use of operating and financial leverage. Knowing how to interpret these signals helps shareholders to evaluate the quality of management’s decisions. Third, the valuation of a company requires forecasting future cash flows and assessing the risk associated with those cash flows. Understanding a company’s use of leverage could help forecast cash flows and in selecting an appropriate discount rate for finding their present value.
Leverage increases the volatility of a company’s earnings and cash flows as well as the risk of lending to or owning a company. Valuation of a company and its equity are affected by the degree of leverage. The greater a company’s leverage, the greater its risk and, hence, the greater the discount rate that should be applied in its valuation. Further, highly leveraged companies have a greater chance of incurring significant losses during downturns, thus accelerating conditions might lead to financial distress and bankruptcy.
Focus on total leverage
The degree of operating leverage gives us an idea of the sensitivity of operating income to changes in revenues. Shareholders need to be concerned about the combined effect of both operating leverage and financial leverage, because both factors contribute to the risk associated with future cash flows.
It’s not a good idea to be too conservative or aggressive towards debt. A temporary increase in debt level to facilitate investment in growth opportunities like acquisitions can be beneficial as long as the it is reduced subsequently.
Most companies will deliver better value by means enhanced share-price performance over a period of time if they were more prudent with the amount of leverage in balance sheet. Investors need to choose companies as per their risk appetite towards leverage.
The writer is associate professor of finance and accounting at IIM-Shillong