Effective Leverage and Optimal Capital Structure
How do small companies choose their capital structure? When is it right for small businesses to fund their operations with loan funds? What are the properties and functions of effective leverage in financial management? These questions relate to the optimal capital structure of a business enterprise – the right mix of debt and equity that maximizes returns on investment and shareholder wealth while minimizing the cost of capital simultaneously. Effective leverage is essential for a sound business strategy designed to maximize the production capacity of a company’s wealth. In this series on effective financial management, we will focus on the question of strategic financing-related and provide some guidance. The primary purpose of this article is to highlight some fundamental financial theories and industry practices in effective financial leverage. For specific financial management strategies, please consult competent professionals.
Please note that the right amount of financial leverage for each company is significantly different based on overall industry dynamics, the competition level of market structure, industrial life cycle stage, and competitive market position. Indeed, as with most market indicators, company-specific leverage positions are only broad-minded concerning expected industry values (average) and generally accepted industry benchmarks and best practices.
Leverage type:
Financial Leverage: The level of financial leverage is the EBIT / EBT profit ratio before interest and tax divided by pre-tax profit. When a business relies on loan funds for its operations – financial leverage is created when a business incurs a fixed financial interest or interest on a loan fund. A specific percentage change in company operating income (EBIT) results in a higher percentage change in the company’s net income (NI) and earnings per share. Indeed, a small percentage change in operating income (EBIT) enlarged to a larger percentage reduction in net income. Financial leverage (DFL) measures a company’s exposure to financial risk or sensitivity to earnings per share (EPS) to changes in EBIT. Therefore, the DFL shows a change in the percentage of earnings per share (EPS) originating from unit percent changes in earnings before interest and tax (EBIT). In general, the short-term funding needs of a company influenced by current sales growth and how effective efficient the company manages networking capital assets minus current liabilities. Note that ongoing short-term funding needs can reflect the need for permanent long-term financing, including appropriate mix evaluations and use of debt and equity capital structures.
Operating Leverage: Fixed operating costs, such as general administration costs, contract employee salaries, and mortgage or lease payments, create operating leverage and tend to increase business risk. The impact of operating leverage is proven when the percentage of specific changes in net sales results in a higher percentage change in operating income (EBIT) – income before interest and tax. Operating leverage calculated as follows: DOL = CM / EBIT-contribution margin divided by profit before interest and tax or the percentage change in EBIT divided by the percentage change in sales (income).
Combined Leverage: The degree of combined leverage (DCL) is a combination of the effects of business risk and financial risk. The level of operating leverage (DOL) and financial leverage (DFL) combine to enlarge the percentage of certain changes in sales to the potential for a far greater percentage change in income or operating income (EBIT). There is a direct relationship between operating leverage degree (DOL), financial leverage (DFL), and combined leverage (DCL). The degree of combined company leverage (DCL) = DOL X DFL or CM / EBIT X EBIT / EBT namely CM / EBT. The combined leverage level (DCL) can also be calculated as the percentage change in EPS divided by the percentage change in sales, that is the percentage change in earnings per share derived from changes in unit percent in sales volume.
Optimal Capital Structure: This is the right use of debt and equity, which minimizes the cost of the company’s capital and maximizes the price of its shares. Please note that the capital structure that is not optimal or the lack of optimal debt and equity can lead to higher funding costs, and the company can reject some capital budgeting projects that will increase shareholder wealth with optimal financing. Furthermore, the effects of different capital structures and different levels of business risk reflected in the company’s income statement. Please note that operating leverage tends to enlarge the impacts of fluctuating sales (income) and produce a percentage change in operating income (EBIT) higher than changes in sales (income) while financial leverage tends to increase the percentage change in EBIT and produce more EPS changes significant. Therefore, changes in sales (income) through operating leverage affect EBIT. This EBIT change through the influence of financial leverage, further influences EPS.
Some Useful Guidelines:
When a company grows, it needs capital that can be funded by equity or debt. Debt financing has costs and benefits. Debt has two significant advantages: Interest paid is tax-deductible, which minimizes the cost of effective debt; and debt brings fixed costs, so shareholders do not have to share their net income if the company is very profitable. On the other hand, high debt ratios indicate higher risk and hence higher capital costs; and if the company fails to get enough income to cover its fixed costs, the company must produce shortages or face bankruptcy. Therefore, companies with fluctuating income and operating cash flows must limit the use of debt financing. Of course, effective cash flow and leverage management are vital for wise and healthy strategies designed to maximize the production capacity of the company’s wealth. Also, strategic analysis, market analysis, and financial analysis must be internally and congruently consistent. EBIT / EPS analysis allows companies to evaluate the impact of different capital structures on operating income and business risk levels. Variability in sales or income over time is a necessary operational risk. Please note that in capital budgeting for specific projects to increase shareholder wealth, he must get more than capital costs or the level of obstacles.
In practice, companies tend to use the target capital structure – a mixture of debt, preferred shares, and general equity with which the company plans to raise funds needed. And because capital structure policy involves a strategic exchange between expected risks and returns, an optimal capital structure policy must find a wise and informed balance between risk and return. Companies must consider business risk, tax position, financial flexibility, and conservatism or managerial aggressiveness. While these factors are crucial in determining the target capital structure, operating conditions can cause the actual capital structure to differ significantly from the optimal capital structure. Therefore, the target capital structure must be used as a guide towards an ideal capital structure that minimizes the weighted average capital costs (WACC) while maximizing shareholder wealth.
