FINANCIAL PERFORMANCE ANALYSIS

Financial Performance Analysis

Financial Performance Analysis

Financial Leverage

The debt in relation to equity in a firm's capital structure-its Long-Term Debt (usually bonds), Preferred Stock and Shareholders' Equity -measured by the Debt-To-Equity Ratio. The more long-term debt, the greater the financial leverage. Shareholders get benefit from financial leverage to the degree that return on the borrowed money beats the interest costs and the market value of their shares increases. For this reason, financial leverage is readily called trading on the equity. Because leverage also means required interest and primary payments and thus eventually the risk of default, how much leverage is enviable is largely a question of stability of earnings. As a rule of thumb, an industrial company with a debt to equity ratio of more than 30% is highly leveraged, exceptions being firms with dependable earnings and cash flow, such as electric utilities.

According to Brigham (1995), long-term debt interest is a fixed cost; financial leverage tends to take over where operating leverage leaves off, further magnifying the effects on earnings per share of changes in sales levels (p. 49). The study also showed that high operating leverage should accompany low financial leverage, and vice versa (p. 55).

Buccino and McKinley study (cited in Block 1997) define operating leverage as the impact of a change in revenue on profit or cash flow. It arises whenever a firm increase its revenues without a proportionate increase in operating expenses. Cash allocated to increasing revenue, such as marketing and business development expenditures, are "Consumed by high fixed expenses." (P. 116)

Rushmore study (as cited in Block, 1997) states that positive operating leverage occurs at the point at which revenue exceeds the total amount of fixed costs. The study further stated that there is uniformity in the definition of financial leverage. "Financial leverage," according to Block (1997), reflects the amount of debt used in the capital structure of the firm. Because debt carries a fixed obligation of interest payments, which has the opportunity to magnify various levels of financial operations. (P. 62)

According to Weston and Brigham (1969), the degree of financial leverage is computed as the percentage change in earnings available to common stockholders associated with a given percentage change in earnings before interest and taxes (P. 143).

Brigham ( 1995) study shows that "The degree of financial leverage (DFL) is defined as the percentage change in earnings per share [EPS] that results from a given percentage change in earnings before interest and taxes (EBIT)”, (Brigham, 1995: 47) and it is calculated as follows:

DFL = %age change in EPS divided by %age change in EBIT

This calculation produces an index number which if, for example, it is 1.43, this means that a 100 percent increase in EBIT would result in a 143 percent increase in earnings per share.

Lortie study (as cited in Rushmore, 1997) observes that small and medium-sized business often has difficulties using quantitative methods large companies use. The study shows that break-even graph is simple and easy to interpret; along with computing operating and financial leverage ...