Why is Earnings Before Interest and Taxes or Net Operating Income generally considered to be independent of Financial Leverage? Why should EBIT actually be influenced by Financial Leverage at high debt levels?
Answer. Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The financial leverage occurs when a firm capital structure contains obligation of fixed financial charges e.g. interest on debentures, dividend on preference shares etc. along with owner's equity to enhance earnings of equity shareholders. The fixed financial charges do not vary with operating profits or EBIT. They are fixed and are to be paid irrespective of level of operating profits or EBIT. The ordinary shareholders of the firm are entitled to residual income i.e. earnings after fixed financial charges. The measure for financial leverage is called DFL (Degree of financial leverage).
Thus the effect of changes in operating of profit or EBIT on the level of earnings per share (EPS) is measured by financial leverage. It is calculated as:
(%-age change in EPS / %-age change in EBIT) or (Increase in EPS / EPS divided by
Increase in EBIT / EBIT)
The financial leverage is favourable when the firm earns more on the investments/assets financed by the sources having fixed charges. It is obvious that the shareholders gain in a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds. Financial Leverage in such cases is therefore also called "Trading on Equity".
Degree of Leverage
Firms that have greater degrees of leverage have greater levels of fixed costs. And as such, they tend to have greater break-even points than do firm's that do not have leverage. The advantage of having greater degrees of leverage is that as a firm's sales volume increases beyond the break-even point, its margins improve. The disadvantage of having greater degrees of leverage is that because the break-even point is higher, which means that the firm is required to achieve a higher sales volume in order to reach the break-even point. In good times when sales are high, a higher degree of leverage allows a firm to maximize profits. In bad times when sales are not as good, the firm is able to minimize its losses by having a lower degree of leverage.
Example:
In the example below, a firm's projected EBIT under two very different cost structures.
Notice the firm experiences the same level of sales, while it has very different cost structures. Now notice what happens to the firm under each option when their sales decrease to $50,000.
When the sales drop to $50,000, the high leverage option declines to its break-even point while the low leverage option minimizes the loss. Now notice what happens to the firm's sales increase to $150,000.
When a firm's sales increase, the cost structure option with the higher degree of leverage is able to maximize the firm's profits.
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