Financial Risk and Financial Leverage might sound complex, but we can break them down into simpler terms.
Table of Contents
- What is Financial Risk?
- What is Financial Leverage?
- Why Does Financial Leverage Matter?
- What is the Degree of financial leverage (DFL)?
- Conclusion
- FAQ
What is Financial Risk?
Imagine you and a few friends decide to start a business together. You all agree to put in some money and share any profits and losses equally. Now, let’s say your business is doing fine, but it still has some risks – like what if customers don’t buy your product? Or what if a competitor opens up nearby? This uncertainty about your business’s future profits and losses is called business risk.
Now, what happens if, instead of everyone putting in the same amount of money, half of your friends decide to loan money to the business, and the other half invest as owners (equity)? This means your business now has some debt (loan) that it needs to pay back along with interest. The people who loaned the money (debtholders) expect to get their fixed payments no matter how the business is doing.If the business faces tough times, you’ll have to make sure the debtholders are paid first before anyone else gets any profit. This puts extra pressure on the owners (stockholders) because they take on more risk. This extra risk, because of the business having debt, is called financial risk.
What is Financial Leverage?
Let’s go back to your business. If your business only used the owners’ money (equity) and didn’t take any loans, all profits and losses would be shared equally among the owners. But, when you take on debt, you’re using financial leverage.
Think of leverage like a seesaw. When you stand right in the middle of the seesaw, it’s balanced, and you don’t have to put in much effort to keep it level. This is like a business that’s funded entirely by equity (the owners’ money) — everything is balanced, and there’s no additional financial pressure. But, as you move to one end and put pressure, the other end goes up.
Similarly, using debt is like standing on one end of the seesaw — it magnifies or leverages your gains and losses. If the business makes a profit, the returns for the equity holders are higher because they don’t have to share it with the debtholders. But, if the business makes a loss, the equity holders feel a greater impact because they still need to pay the debt.
Why Does Financial Leverage Matter?
Let’s say you invested 100,000 dollars of your own money (equity) in your business. If your company makes a 10,000 dollars profit, that’s a 10% return on your investment. But what if you only put in 50,000 dollars of your own money and borrowed 50,000 dollars as debt instead? If the business still makes 10,000 dollars, you get a higher return on your own 50,000 dollars because you didn’t have to use all your money to earn the same profit.
However, the flip side is that if your business only makes 2,000 dollars in profit, you might still have to pay back your debt, which reduces your share of the profits. And if the business doesn’t make enough, you might end up with a loss even though you made a small profit before paying off debt.
In essence, financial leverage means using debt to try and increase returns for equity holders. But it also increases financial risk because if the business underperforms, equity holders bear a larger portion of the loss.
To access and analyze this financial risk properly, we need to understand the calculation of the degree of financial leverage (DFL).
What is the Degree of financial leverage (DFL)?
DFL stands for Degree of Financial Leverage. It measures how sensitive a company’s Earnings Per Share (EPS) is to changes in its operating profit (EBIT). Essentially, it shows how much the EPS will change for every 1% change in operating profit.
The DFL formula helps understand how debt or financial costs (like interest) impact the company’s earnings available to shareholders. A higher DFL indicates that the company’s earnings are more sensitive to changes in its operating profits (EBIT), which implies more risk. If operating profit (EBIT) changes by a small percentage, a high DFL means the EPS will change by a much larger percentage.
In this blog “How to calculate the degree of financial leverage (DFL)” I’ve explained the whole process of calculating the DFL.
Conclusion
Now that you have understood what financial risk, financial leverage, and the degree of financial leverage means, it’s time for you to start learning the process of calculation too.
Let me know if this blog has helped you or if I’ve missed out on something in the comment box.
FAQ
1. What is the difference between financial risk and business risk?
Financial risk refers to the risk associated with a company’s use of debt, which affects its financial obligations. Business risk, on the other hand, is the inherent risk related to the company’s core operations, such as fluctuating sales or increased competition.
2. How does financial leverage impact a company’s profitability?
Financial leverage amplifies a company’s potential profitability by using borrowed funds (debt) in addition to equity. While it can increase returns for equity holders if the business is profitable, it also increases the risk of larger losses if the business underperforms.
3. What is the Degree of Financial Leverage (DFL), and how is it calculated?
The Degree of Financial Leverage (DFL) measures how sensitive a company’s Earnings Per share (EPS) is to changes in its Earnings Before Interest and Taxes (EBIT).
Visit the blog “How to calculate the degree of financial leverage (DFL)” for complete knowledge.
4. What are the key risks of using high financial leverage?
High financial leverage is beneficial when a company is confident about generating consistent and high returns on investment. This allows equity holders to benefit from higher returns without having to invest additional equity. However, it’s risky if the company’s profits are uncertain.
5. What are the key risks of using high financial leverage?
The primary risk of using high financial leverage is the increased obligation to meet fixed financial payments, such as interest on debt. If the business faces a downturn, these fixed payments can lead to greater financial strain, potentially resulting in financial distress or bankruptcy.
