2-Assessment

2)- Assessment of level of financial leverage

There are several different ways of quantifying financial leverage. One such measure is degree of financial leverage found in most financial management textbooks. The degree of financial leverage DFL is defined as the change in earnings per share (measured by profit after tax PAT divided by number of shares as above and further explained in Chapter 13) from one period to the next, as a result of a change in earnings (EBIT) when debt financing was increased. DFL is sometimes measured by the following formula

DFL = % change in (EPS) / % change in (EBIT)

If the number of shares outstanding does not change,the change in EPS is equal to the change in PAT, and DFL can be written as

DFL = ((PAT_t-PAT_t-1)/PAT_t-1) / ((EBIT_t-EBIT_t-1)/EBIT_t-1)

where PAT = profit after tax: EBIT = earnings before interest and taxes; t=time

It can be shown that the calculation of DFL can be further simplified as

DFL = EBIT / PBT

In Company X, DFL for the 20% level of financial leverage is calculated at

DFL = 3,500 / 3,116 = 1.12

Table T-11.1 shows that DFL varies from 1.12 at the 20% of debt to 1.78 at the 80% of debt.

This measure of degree of financial leverage DFL is affected by the initial earnings EBIT. DFL can only show which alternative of a range of alternatives (as in the above example) will generate more financial leverage, and which less. This measure of financial leverage is not useful to compare companies whose initial profits and earnings that are most certainly different, and it is also inadequate for comparisons over time for the same company.

Another measure of financial leverage, called financial leverage index FLI, attempts to capture how return on equity increases when debt is used. FLI is calculated as

FLI = ROE / ROA

For instance, for the 20% level of debt in Company X, the financial leverage index is

FLI = 0.10 / 0.08 = 1.25

Table T-11.1 shows that FLI increases from 1.25 for the 20% level of debt to 5 at the 80% level of debt. Actually, the financial leverage index is nothing more than total assets divided by equity. The inverse of this statistic is the percentage of equity in total assets, which is already available from the normalized balance sheet. The financial leverage index gives the illusion of showing how much more profitable a leveraged company is, but earnings are eliminated by having them in numerator and denominator.

Because of the limited usefulness of these two former statistics, the simpler but more robust approach is to measure the relative size of debt in total assets

% Debt financing = Debt / Total Assets

This seems unambiguous by comparison, and is recommended. To the extent that the choice is essentially between long term debt and equity, the same information can be obtained by looking directly at the proportion of equity financing, which is the essential information we uncovered in the financial leverage index above:

% Equity financing = Equity / Total Assets

To illustrate the calculation of these ratios, let us take J.C. Penney, a major American department store. From Table T-6.10 - J.C. Penney Company Inc. - Balance Sheets, we obtain the amount for total assets of $ 23,638 millions, equity of $ 7,169 millions and total liabilities $ 16,469 millions. This gives

% Debt financing = 16,469 / 23,638 = .697 or 70%

which (except for spreadsheet rounding error) is the sum of proportions of liabilities in Table T-5.14 - J.C. Penney Company Inc. - Normalized Balance Sheets; and

% Equity financing = 7,169 / 23,638 = .303 or 30%

We note in Table T-5.12 - J.C. Penney Company Inc. - Normalized Balance Sheet, that the capital structure has practically not changed from the previous year. The retail industry is mature and relatively stable. The capital structure seems fully worked out and similar to retail industry statistics, as can be seen from Table T-11.17 - Proportion of equity average and standard deviation in eight US sectors in 1999. That table shows that the retail sector has one of the lowest dispersion of equity proportions. Compared to the entire retail sector, J.C. Penney's proportion of equity of 30% is in line with the entire retail sector equity proportion of 34%. When we compare J.C. Penney equity proportion with the department stores industries, J.C. Penney is clearly much more leveraged than the other department stores which average an equity proportion of over 40%. The disparity is even greater if prior years are compared: in 1998 the average equity proportion was over 45%, and in 1996 it was as high as 52.8%. This is a area that an analyst would want to investigate. Why do department stores have such a difficult access (or reluctance) to borrowing? It is clear that J.C. Penney is a very well known company and does not have similar difficulties (or apprehension).

The most common and straightforward assessment of financial leverage is to relate debt to equity

Debt to equity = Total Debt / Equity

Robert Morris Associates use net worth instead of total equity

Debt to worth = Total Debt / Net Worth

In our example in the previous section, Table T-11.1 shows that long term debt to equity increased from 0.25 to 4 as long term debt increase from 20% to 80% of total assets. There are several variations of the debt to equity ratio that will be encountered later.

We return to J.C. Penney to demonstrate the calculation of the debt to equity ratio. From Table T-6.10 - J.C. Penney Company Inc. - Balance Sheets, we obtain the amounts for equity of $ 7,169 millions and total liabilities of $ 16,469 millions. This gives

Debt to equity = 16,469 / 7,169 = 2.30

which is indeed the value found in Table T-5.20, J.C. Penney Company Inc. - Ratios. We also note in Table T-5.20 that the ratio has increased slightly from 2.19 in the previous year. To use RMA's format, equity of $7,169 millions must be reduced by the intangibles of $ 2,933 millions to obtain a net worth of $ 4, 236 millions.The ratio is

Debt to worth = 16,469 / 4,236 = 3.89

When we compare J.C. Penney debt to worth ratio of 3.89 to industry average of 1.8, confirmation of our prior observation of high financial leverage is confirmed. In addition, J.C. Penney value is higher than even the highest quartile of only 2.8. This means that J.C. Penney leverage is not high, it is extremely high. Moreover, industry recent debt to worth values are at a historic high compared to the previous five years when the average was as low as 1.0.

The decision to use debt or not pertains primarily to long term debt. In fact, short term debt is sometimes referred to as spontaneous financing, implying that this borrowing is available almost automatically. A more precise measure of management strategy in using financial leverage can be obtained with the percentage of long term debt in total assets in the normalized balance sheet

% Long term debt financing = Long Term Debt / Total Assets

Returning to the example of the previous section once again, Table T-11.1 shows the proportion of long term debt financing it the first line of the schedule. Sometimes, long term debt is related to equity to reflect where the bulk of permanent financing comes from:

LTD to equity = Long term debt / equity

For J.C. Penney, the amounts for long term debt of $ 7,143 millions and total assets of $ 23,638 millions are obtained from Table T-6.10 - J.C. Penney Company Inc. - Balance Sheets. This gives the proportion of long term financing in 1999

% Long term debt financing = 7,143 / 23,638 = .302 or 30%

which can be found in Table T-5.12, J.C. Penney Company Inc. - Normalized Balance Sheet. Table T-5.12 that also shows that the proportion of long term financing by J.C. Penney was the same the previous year. When these statistics are compared to averages for the department store industry, the source of J.C. Penney high financial leverage is revealed: the average for the industry is only 22% in 1999, was 16% in 1998, and was even lower in 1997 with 11%. This confirms that J.C. Penney has an easier access to capital markets than most all the other department stores. Finally, we calculate long term debt to equity ratio of J.C. Penney in 1999, by taking the amounts for long term debt of $7,143 and equity of $ 7,169, which gives

LTD to equity = 7,143 / 7,169 = 1.0

See review questions Q-11B2.1 through Q-11B2.5.

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