A corporation raises capital to finance its operations by borrowing money or selling the company’s ownership shares to the public. A corporation can only remain viable if it generates enough income to offset the costs associated with its financing—after all, some of its revenue needs to be paid to shareholders, bondholders, and other creditors. Thus, the structure of a corporation’s financing plans has a significant impact on how much operating income it needs to generate.
Corporate Financing and Financial Leverage
Corporations often take advantage of their wealth by borrowing money to increase production and, by extension, to earn. Financial leverage comes from any capital issue that has a fixed interest payment, such as bonds or preferred stock. Issuing common stock would not be considered a form of financial leverage, because the required return on equity (ROE) is not fixed and because dividend payments may be suspended, unlike interest on debt.
A common formula for calculating financial leverage is called the degree of financial leverage (DFL). The formula shows the proportionate change in net income following a change in a corporation’s capital structure. Changes in the DFL can either result from a change in the total amount of the loan or a change in the interest rate paid on the existing loan.
Idfl=EBIT. % change in% Change in EPSIWhere:eps=earnings per shareEBIT=Earnings before interest and taxI
Profitability and earnings before interest and taxes
Earnings before interest and taxes (EBIT) measures all profits before interest and tax payments are taken apart, which differentiates the capital structure and focuses solely on how well a company generates profits.
EBIT is one of the most commonly used indicators to measure the profitability of a business and is often used interchangeably with “operating income.” It does not take into account the change in cost of capital. However, a corporation can enjoy operating profit only after paying its creditors. Even if earnings are low, the corporation still has interest payment obligations. A company with high EBIT may fall short of its break-even point if it is heavily leveraged. It would be a mistake to focus only on EBIT without considering financial leverage.
Rising interest cost raises the break-even point of the firm. The break-even point will not appear in the EBIT figure itself—interest payments do not factor into operating income—but it does affect a firm’s overall profitability. It would have to report higher income to offset the additional capital costs.
Additionally, the high degree of financial leverage increases the volatility of a company’s stock price. If the company has issued a stock option, the additional volatility directly increases the expense associated with those options, further hurting the company’s bottom line.