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Financial leverage
If you rely more on debt than equity when you raise capital, your business will have a higher debt-equity ratio As the ratio increases, the financial leverage of the business also increases.
Financial leverage is the use of debt to magnify the rate of return on shareholders' equity. Return on shareholder equity is often called return on equity. Return on equity is the percentage change in income divided by the value of equity at the beginning of the period.
For example, if you earn $10,000 in income for the 12 months ended in December, and had $100,000 in equity at the beginning of the year, your ROE is 10%. The higher your income on the $100,000 equity, the greater your return on equity. Alternatively, the lower the shareholder equity, the higher your return on equity for a given amount of income.
Exhibit A, below, shows a 12-month income statement for three debt-equity ratios: 25%, 100%, and 400% (A 100% debt-equity ratio means that for every $1 of debt, the company uses $1 of equity. Total capital is the sum of debt and equity):
| Debt-equity ratio (Exhibit A) |
25% |
100% |
400% |
| Net sales |
$150,000 |
$150,000 |
$150,000 |
| Expenses: |
-- |
-- |
-- |
| Cost of goods sold |
$90,000 |
$90,000 |
$90,000 |
| Fixed costs |
$40,000 |
$40,000 |
$40,000 |
| Interest expense |
$1,600 |
$4,000 |
$6,400 |
| Pretax income |
$18,400 |
$16,000 |
$13,600 |
| Income tax (40%) |
$7,360 |
$6,400 |
$5,440 |
| Net income |
$11,040 |
$9,600 |
$8,160 |
| Return on equity |
13.8% |
19.2% |
40.8% |
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| Debt (8% interest) |
$20,000 |
$50,000 |
$80,000 |
| Equity |
$80,000 |
$50,000 |
$20,000 |
| Total capital |
$100,000 |
$100,000 |
$100,000 |
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Exhibit A shows that cost of goods sold is equal to 60% of net sales and fixed costs are $40,000. The company borrows at 8%, deducting the interest expense from its taxable income. If the debt-equity ratio at the beginning of the year were 25%, net income of $11,040 would have earned a return on equity of 13.8%. If the ratio were 100%, return on equity would be 19.2%. At a debt-equity ratio of 400%, return on equity would be 40.8%.
Exhibit B illustrates positive financial leverage, which benefits the shareholders. Net sales have increased by a third to $200,000. Cost of goods sold, at 60% of net sales, and fixed costs, at $40,000, are constant. In Exhibit B's case, net income rises substantially as a result of higher sales. For all three debt-equity ratios, return on equity more than doubles. For example, return on equity for a 25% debt-equity ratio is now 28.8%, up from 13.8% at the lower sales level:
| Debt-equity ratio (Exhibit B) |
25% |
100% |
400% |
| Net sales |
$200,000 |
$200,000 |
$200,000 |
| Expenses: |
-- |
-- |
-- |
| Cost of goods sold |
$120,000 |
$120,000 |
$120,000 |
| Fixed costs |
$40,000 |
$40,000 |
$40,000 |
| Interest expense |
$1,600 |
$4,000 |
$6,400 |
| Pretax income |
$38,400 |
$36,000 |
$33,600 |
| Income tax (40%) |
$15,360 |
$14,400 |
$13,440 |
| Net income |
$23,040 |
$21,600 |
$20,160 |
| Return on equity |
28.8% |
43.2% |
100.8% |
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| Debt (8% interest) |
$20,000 |
$50,000 |
$80,000 |
| Equity |
$80,000 |
$50,000 |
$20,000 |
| Total capital |
$100,000 |
$100,000 |
$100,000 |
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Financial leverage is a two-edged sword, however. If sales fall, a business still has to pay its fixed costs and the interest on debt. The lower net income causes your return on equity to drop sharply, even turning negative.
Exhibit C shows how return on equity deteriorates when sales slip $25,000 to $125,000. Cost of goods sold and fixed costs are constant. For all three debt-equity ratios, return on equity falls by more than half (remember, it took a $50,000 increase in sales for return on equity to more than double). For example, return on equity for a 25% debt-equity ratio is now 6.3%, less than half of the 13.8% return on equity earned with net sales of $150,000:
| Debt-equity ratio (Exhibit C) |
25% |
100% |
400% |
| Net sales |
$125,000 |
$125,000 |
$125,000 |
| Expenses: |
-- |
-- |
-- |
| Cost of goods sold |
$75,000 |
$75,000 |
$75,000 |
| Fixed costs |
$40,000 |
$40,000 |
$40,000 |
| Interest expense |
$1,600 |
$4,000 |
$6,400 |
| Pretax income |
$8,400 |
$6,000 |
$3,600 |
| Income tax (40%) |
$3,360 |
$2,400 |
$1,440 |
| Net income |
$5,040 |
$3,600 |
$2,160 |
| Return on equity |
6.3% |
7.2% |
10.8% |
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| Debt (8% interest) |
$20,000 |
$50,000 |
$80,000 |
| Equity |
$80,000 |
$50,000 |
$20,000 |
| Total capital |
$100,000 |
$100,000 |
$100,000 |
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Your debt-equity ratio is likely to change as your company grows. If you manage a profitable business and retain most of your earnings, the debt-equity ratio drops over time. A lower debt-equity ratio will make for easier loan negotiations in the event you need to borrow money in the future.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Operating leverage
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