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Home » Blog » What is Financial Leverage and why is it called ‘Trading on Equity’? Explain the effect of Financial Leverage on EPS with the help of an example

What is Financial Leverage and why is it called ‘Trading on Equity’? Explain the effect of Financial Leverage on EPS with the help of an example

Financial Leverage refers to the use of borrowed funds (debt) to finance investments, with the aim of increasing the potential return on equity (ROE). By utilizing debt, a company can amplify its earnings, as long as the returns generated from the borrowed funds exceed the cost of the debt.

Why is it Called ‘Trading on Equity’?

The term “trading on equity” describes the practice of using debt to enhance the returns available to equity shareholders. When a company borrows money, it “trades” its equity for additional funds, expecting to earn more on the investments made with the debt than it pays in interest. This leverage can lead to higher returns on equity if the investments are successful.

Effect of Financial Leverage on Earnings Per Share (EPS)

Financial leverage can significantly influence a company’s earnings per share (EPS). The use of debt increases fixed interest expenses, which can magnify the impact on EPS when a company performs well. Conversely, if the company does poorly, the fixed nature of interest payments can lead to decreased EPS.

Example

Consider a hypothetical company with the following financials:

  • Equity: $1,000,000
  • Debt: $500,000
  • Interest Rate on Debt: 10%
  • Operating Income (EBIT): $300,000
  1. Calculate Interest Expense:
    • Interest = Debt × Interest Rate
    • Interest = $500,000 × 10% = $50,000
  2. Calculate Earnings Before Tax (EBT):
    • EBT = EBIT – Interest Expense
    • EBT = $300,000 – $50,000 = $250,000
  3. Assuming a Tax Rate of 30%:
    • Net Income = EBT × (1 – Tax Rate)
    • Net Income = $250,000 × (1 – 0.30) = $250,000 × 0.70 = $175,000
  4. Calculate EPS:
    • Shares Outstanding = 100,000
    • EPS = Net Income / Shares Outstanding
    • EPS = $175,000 / 100,000 = $1.75

Now, assume the company invests the borrowed funds, leading to an increase in EBIT to $400,000.

  1. New Interest Expense (remains the same):
    • Interest = $50,000
  2. New EBT:
    • New EBT = New EBIT – Interest Expense
    • New EBT = $400,000 – $50,000 = $350,000
  3. New Net Income:
    • New Net Income = $350,000 × (1 – 0.30) = $350,000 × 0.70 = $245,000
  4. New EPS:
    • New EPS = New Net Income / Shares Outstanding
    • New EPS = $245,000 / 100,000 = $2.45

Conclusion

In this example, financial leverage increased the company’s EPS from $1.75 to $2.45, illustrating how leveraging debt can enhance returns to equity shareholders. However, it’s essential to recognize that increased financial leverage also carries risks. If the company faces a downturn, the fixed interest obligations can result in lower or negative earnings, emphasizing the need for careful management of debt levels.

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