Measures of Leverage

I|nanc|a| Leverage and kCL llnanclal leverage (or presence of debL on Lhe balance sheeL) ls a
double edged sword whlle lL can mulLlply reLurns Lo equlLy holders when Llmes are good lL can
dampen Lhe reLurns (Lo equlLy holders as debL holders geL a predeLermlned reLurn as long as Lhe
company does noL defaulL on lLs obllgaLlons) durlng recesslons and slowdowns
LeLs see how
lease refer Lo Lhe 8CL Lab ln Lhe xls flle Leveragexls lL has flnanclal sLaLemenLs for Lhe company
glven four scenarlos
Scenarlo 1 8oom 1lmes and Leveraged 8alance SheeL
Scenarlo 2 8oom 1lmes and no Leverage on Lhe 8alance SheeL
Scenarlo3 Recessionary Phase and Leveraged Balance Sheet
Scenario4: Recessionary Phase and No Leverage on Lhe 8alance SheeL

n all the four cases the company has assets of 20,000, in the scenarios with no leverage( i.e 2 and 4
these assets are financed entirely by equity and in the scenarios with leverage these assets are
financed by 75% debt and 25% equity(extreme example mind you but all the exaggeration is for
illustrative purposes only). t is also assumed to simplify things that all the liabilities are debt.
All the assumptions are listed down in the column A and applicable equally well to all the four
scenarios. The rate of interest is assumed at 9% of the total debt outstanding.
When the going is good and the sales are robust, the leveraged company (scenario 1) generates a
handsome ROE (Net Profit/Equity) of 15%, and the unleveraged balance sheet is able to generate an
ROE of only 8.13%.
However when the times are not so good and the company experiences a 30% fall in sales, the same
leveraged balance sheet generates a negative ROE of (1)%. However the unleveraged balance sheet
still generates a moderate return of 4.13%!.
Closely linked to the use of financial leverage to multiply returns are the concepts of Leveraged
Buyout and Leveraged Recapitalisation
LBOs are simply the buyout of a target firm with a large amount of debt and a relatively small amount
of equity. Suppose a firm is entirely financed by equity, an acquirer may find the capital structure sub-
optimal to generate adequate returns to the equity holders and hence may want to lever the balance
sheet with some amount of debt. Other reason for going for LBO maybe, is that the acquirer does not
have enough cash (and thus cannot bring in its own equity) to entirely buyout the company on its own
and does not want to bring in equity from other sources (thereby diluting its ownership interests). So it
may choose to buyout a firm using large amounts of debt and bringing in a small amount of its own
equity. Most of the debt will be secured by the assets of firm being acquired. So a lbo candidate
should have a good asset base...and stable cashflows so that the lenders feel confident that the firm
can honour its scheduled interest and principal payments. n some cases only the senior debt may be
secured and Balance sheet may have mezzanine debt, interest on which is paid after senior debt
holders have been paid but before the equity holders are paid. Mezzanine debt is called so because it
sits between senior debt and equity on a balance sheet and hence attracts higher rate of interest than
senior debt due to greater risk. Some of the debt (bonds) used to finance the LBO may be junk bonds
(unsecured and the last to be paid of all the debts), which due to their added riskiness attract a rate of
interest which is higher than mezzanine debt and much higher than senior debt. The cash flows from
the business are then used to make the interest and principal payments over the years(and the capital
structure veers towards lower debt/equity over time)
MBO: Management Buyout....simply LBOs where the equity portion is contributed by the
management of the firm being acquired (and thus the management acquires the firm from its existing
owners)
Leveraged recapitaIisation: Similar to LBO, in that the capital structure of the firm changes with debt
replacing a part of equity (share buybacks financed with debt is one of the ways) so as to multiply
returns to the equity holders but the majority ownership of the firm does not change

Operating Leverage: Operating leverage, a company with higher fixed and lower variable costs has
higher operating leverage than a company with lower fixed and higher variable costs (all the costs are
here refer to the operating costs or costs which form a part of COGS or Selling, General and
Administrative expenses). The concept is analogous to financial leverage in that if the ratio of fixed
costs to variable costs is high the company will do well in boom times but in not so good times the
higher fixed costs will result in a lower EBTDA and hence lower profitability (interests are similar to
fixed costs)
Please refer to the tab Operating leverage in the excel sheet. The two companies A and B go through
3 phases (Normal, Boom and Recession). Both the companies generate the same Sales and Gross
Profits as each other in all the three phases. The company A has however a lower Fixed SG&A and a
higher SG&A per unit the company B has a higher Fixed SG&A and a lower SG&A per unit sold
(hence higher leverage), the company A therefore does better than B in recessionary scenarios but
fails to match up to B in case of Boom Time scenario.