Understanding the two approaches to gauging leverage of a business…

Companies and Sectors | Published on 19th April 2018 | 236

What do we understand by leverage? As the name suggests, it refers to the strategic use of debt (as a lever) to reduce your cost of capital. The logic here is that the cost of debt is lower than the cost of equity. As a result, by adding debt to your capital structure you end up reducing your average cost of capital. But does it always work that way? While it is true that debt cost less than equity, it also needs to be remembered that debt has a commitment in the form of interest and principal repayments. Hence in cyclicals businesses, this becomes a major source of financial risk.

What is gauging leveraging all about? Essentially, gauging leverage is about understanding this very delicate trade-off. How do you use leverage to reduce your average cost of capital but at the same time also ensure that it does not expose you to financial risk? Here, when we talk of financial risk we are referring to the probability that the company may not be able to service the interest and principal repayments through its existing cash flows. Effectively, there are two aspects to gauging leverage viz. evaluating the quantum of debt and evaluating the cost of debt.

Evaluating leverage as the quantum of debt…

Let us understand the concept of quantum of debt with a live illustration

Balance Sheet of Lever Ltd. for the fiscal year 2017-18

Liabilities

Amount

Assets

Amount

Equity Capital

20,00,000

Land

30,00,000

General Reserves

30,00,000

Building

20,00,000

Share Premium A/C

10,00,000

Plant & Machinery

60,00,000

Total Equity

60,00,000

Other LT Assets

10,00,000

Term Loans

60,00,000

Total Fixed Assets

1,20,00,000

Bonds

30,00,000

Cash on Hand

15,00,000

Long Term Debt

90,00,000

Bills Receivable

20,00,000

Current Liabilities

15,00,000

Inventories

30,00,000

Short Term Loans

30,00,000

Advances given

10,00,000

Short term Liabilities

45,00,000

Total Current Assets

75,00,000

Total Liabilities

1,95,00,000

Total Assets

1,95,00,000

The liabilities side of the balance sheet consists of equity, long term debt and short debt. The assets side of the balance sheet consists of fixed assets and current assets. There are two approaches to measuring the quantum of leverage.

Total Leverage Ratio = Total Assets / Equity

Total Leverage Ratio = 1,95,00,000 / 60,00,000 = 3.25 times

This is a normal leverage for companies in sectors like metals, cement and capital goods which are capital intensive. However, in case of sectors that are more consumer-facing, these high levels of leverage are not called for. However, this approach to leverage can be quite misleading as it considers the total liabilities which is a mix of short term and long term liabilities. Normally, short term liabilities are financed by the current assets and hence do not really impact the financial risk of the company. What is a better way to look at quantum of leverage? It is pure leverage…

Pure Leverage Ratio = Long term debt / total equity

Pure leverage ratio = 90,00,000 / 60,00,000 = 1.50 times

The pure leverage ratio is more indicative of the quantum of leverage as it ignores the impact of current liabilities and only looks at the long term debt of the company. However, the second dimension that you need to understand about leverage is the cost of leverage.

Evaluating leverage on the basis of the coverage of debt servicing…

To delve deeper into the concept of cost of leverage, let us look at how good he cash flows of the company are to cover the servicing of the debt. Look at the case study below…

Particulars

Amount

Long Term Debt

Rs.90,00,000

Cost of Debt

9%

Annual Interest payout

Rs.8,10,000

EBITDA of the Company

Rs.20,00,000

Depreciation

Rs.10,00,000

Earnings before Interest and Tax (EBIT)

Rs.10,00,000

Interest Cost

Rs.8,10,000

Profit before Tax

Rs.1,90,000

Interest Coverage = EBIT / Interest

1.23 times

Before we get into the interest coverage review, here is an interest point to understand. Why have we considered EBIT instead of EBITDA, since depreciation is a non-cash charge? There is a reason for that. Why do we charge depreciation? It is charged so that the company gets tax shields on the depreciation write-off and that can be used to replenish the plant and machinery over time. Therefore you can use the depreciation generated funds. You reference has to be EBIT only.

In the above case, the interest coverage is quite precarious at 1.23. The EBIT just about covers the interest cost. Even though, the company is comfortable in terms of quantum of leverage, the cost of debt is quite high. Therefore the company needs to either focus on negotiating for a lower cost loan or they will have to reduce the quantum of debt. That is how leverage is gauged.

Understanding the currency risk aspect in leverage…

While understanding leverage there is another aspect of currency risk that needs to be understood. This is in case of foreign currency borrowings as in the case of External Commercial Borrowings (ECB) and Foreign Currency Convertible Bonds (FCCBs). If between the time the bond is issued and the bond is redeemed, if the INR depreciates against the US Dollar, then the rupee liability of the company can shoot up substantially. This is a unique risk pertaining to foreign currency borrowings that add to your leverage risk!