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Category: Finance
Tags: CostsFinanceLeverageProfitRisk
Entities: Financial LeverageFixed CostsLeverageOperating LeverageProfit
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Today I want to speak to you about a very fascinating concept in finance called leverages. Leverage denotes a disproportionate impact on the bottom line due to a certain change in the top
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line. And leverages are caused by the presence of fixed costs in your costing structure.
If all your costs are variable, then when sales goes up, costs go up in the
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same proportion. Profit goes up in the same proportion.
If sales goes up by 10%, profit will go up by 10%. If sales goes up by 100%, profit will go up by 100%.
But when you have fixed costs in your
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costing structure, what does the graph look like? It's a straight line.
Fixed costs also don't remain fixed forever. But when fixed costs go up, they go up with a jerk.
So it's a step graph. But in this phase, while the fixed cost doesn't go up, when your sales goes up,
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costs being fixed, costs do not move up. And the gap between income and cost becomes wider and wider.
This in finance is called the leverage effect. Guys, where does the word leverage come from?
It is derived from an engineering
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term called lever. And what is the function of a lever?
The function of a lever is if you wish to lift a weight and you take the help of a lever is a mechanical device. If you take the help of a lever, the effort that you exert at one end is less and
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the weight that you lift on the other end is more. It's a magnifier effect.
We are talking about leverages in finance. In engineering, lever works on the principle of fulcrum.
In finance, the role of fulcrum is played by fixed
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costs. The effort on increasing sales is less, but the impact on the bottom line is more.
Financial leverages. Since fixed costs cause leverages, but there are two types of fixed costs.
There are those fixed costs
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which are necessary to run operations. Those are called operating fixed costs.
And there are those fixed costs. It doesn't matter to operations whether you incur them or not.
Those are merely the financial fixed costs or the interest.
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Operating fixed costs are by and large beyond your control. They depend upon the nature of operations.
You don't decide them. But financial fixed costs are in your control because to borrow or not to borrow is a choice.
Nobody puts a gun and said you got to borrow. Guys,
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the presence of fixed costs gives you leverages and therefore you can work out what is known as a leverage multiple because leverage denotes a disproportionate impact on the bottom line and the multiple will tell you to what extent it will be disproportionate.
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Operating fixed costs give you operating leverage multiple and financial fixed costs give you financial leverage multiple. Let's say an organization's operating leverage multiple happens to be three and the financial leverage multiple happens to be four.
So this
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organization will now have a combined leverage of 12. 3 multiplied by 4.
Now what does a combined leverage of 12 mean? It means if the sales of this organization goes up by 100%.
profit will go up by 1,200%.
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If sales goes up by 10%, profit goes up by 120%. Nobody will complain.
But if sales drops by 10%, profit will drop by 120%, it goes into the red. And therefore, highly leveraged companies
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become highly risky companies. So you as a person running a business or the CEO must use this to your advantage.
If your operating leverages are high and mind you operating fixed costs are not in your control and therefore the operating
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leverage multiple is a given. So those organizations which have a high operating leverage multiple will take it as a sign and prudent organizations will try and see that they keep their financial leverages under check.
How do you do that? If you have a high operating leverage multiple then you
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should try and fund expansions etc through equity rather than debt but those organizations which have a low operating leverage multiple can afford to borrow more. So folks if you have to analyze an organization's profit loss
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account why would you want to analyze? There are many many occasions where you know somebody approaches you and you have to take an exposure.
You want to know who is this organization? What what how risky are they?
Should I should I can I stick my neck out or not. So folks, if you pick up the profit loss
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account, study their fixed costs, work out the leverage multiple, you will find all organizations can eventually be broken up into four types. If you list out the operating leverage and financial leverage multiple, chances
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are the first organization may have under operating leverages heading a letter H. That means high and under financial leverages there could be another H.
Possibility number two, you might find an L and an L. In both cases,
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a low. Possibility number three, you might find an H under operating leverage and a low under financial leverage or a low under operating leverage and a high under financial leverage.
There only four possibilities. Let's say this first company approaches you.
Both are high.
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Operating leverage is high, financial leverages are high. And this company for example says you know I can give you a large order, very large order.
But to everybody you're giving a 30-day credit, can you give me 300 days credit? Now you
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need to take a call. If you refuse, you lose a big order.
But if you say yes to the wrong kind of a person, you may not be able to recover your money. Or you could be a banker.
Somebody comes and approaches you for a loan. You want to decide can I give a loan to this person or not?
So you say, let me do some
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leverage analysis. And you find this fellow has got a high under operating leverages and a high under financial leverages.
How do you interpret this organization? How would you do a risk profiling?
Let me help you with the first one. I want you to get involved from the second
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onwards. You see a letter H under a column operating leverage.
How can your operating leverages be high? What causes operating leverages?
Operating leverages are caused by the presence of operating fixed costs. Are operating fixed costs
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in your control or beyond your control? By and large, beyond your control.
Does it give you an idea about the kind of industry in which this organization functions? It seems to be functioning within an industry where the operating fixed costs which are not in your
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control are more probably one of the new economy companies. Maybe it runs an IT company.
Maybe it runs a hotel. Maybe it runs an airline.
If the operating fixed costs are more that means the break even point on operations will be late. That mean this company will have to function
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at a 50 55% of installed capacity utilization before they break even. And once they break even they will start enjoying the benefit of leverage.
What is the benefit of leverage? Every slight increase in turnover takes the profit shooting upward.
Let me repeat how many
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conclusions did we reach looking at one letter H under a column operating leverages. This organization has got high operating leverages.
That means this organization's operating fixed costs must be more. This we also get an idea about the kind of industry in which
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they function. you know the old economy companies like for example if you're running a steel manufacturing company if you have 10,000 employees chances are 6,000 are unskilled another 3,000 are semi-skilled and those expensive engineers at the top are handful of them
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whereas if you're running an IT company of thousand people maybe 975 people will be expensive so new economy company high operating leverages high operating fixed cost gives you an idea about the kind of industry in which they are in gives gives you an idea of the kind of break
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even point they have. And once they break even, they will start enjoying the benefit of leverages.
Then you move to the next column. What do you find?
Another H. How can financial leverages be hedged?
I what causes financial leverages? Interest.
Does it give you an
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idea about this company's temperament towards borrowing? Appears to be a liberal borrower.
Already this company had to function at 50 555% of installed capacity to break even. Now you realize they'll have to produce some more.
They'll have to sell
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some more and the break even point would have jumped up from 50 55 to 70 75%. But once this organization breaks even the combined leverage is so phenomenal that every slight increase in turnover will take the profit zooming upwards.
But on
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the flip side, at the first sign of recession, this profit will come sliding down and the company would go into the red. I ask you to put this company on a risk scale of 1 to 10.
One being low risk, 10 being high risk. Where would
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you put this company? Pretty close to 10.
This organization comes to you saying, I can give you a very very large order. If you give me a one-year credit or a 10-month credit, would you be comfortable doing so?
This company goes to a bank. I want a loan.
Do you think the banker would want to entertain this
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organization? This company comes to you, will you buy my shares?
Would you like to buy shares? Shares, I might.
Now, why will I buy the shares and not give them a loan? Folks, I don't want any long-term relationship with this company.
But a relationship that I can enter into by
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picking up a phone and get out by picking up a phone, I don't mind. You understand that the difference between somebody who buys their shares just being impressed by this company's profit and somebody else who buys the shares having done leverage analysis.
Please understand when this company is making a
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profit the leverages are working in its favor. But those people who buy the shares just by being impressed by the profit will next time remember we are holding shares in this company where they're reading a newspaper write up that this company has folded up.
But the fellow who buys the shares having done
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leverage analysis will understand this company is making a profit but I'm sticking my neck out high leverage company and therefore having bought the share this fellow will watch this company like a hawk and while the going is good this fellow will remain invested and the day the downturn starts he'll be
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the first one on the phone to sell and get out and let's analyze the second company you find a letter L under operating leverage and a letter L under financial leverage both are How do you analyze this company? Operating leverages are low.
What causes
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operating leverages? Presence of operating fixed costs.
Are operating fixed costs in your control or beyond your control? By and large, beyond your control.
Lucky organization. Those fixed costs which are not in your control are
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less. Does it give you an idea about the break even point of this company on operations?
Quick. Maybe they break even on 10 15% of installed capacity utilization.
Quick break even long way to travel before you touch full
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capacity. And then you look at the next column.
What do you see? Another L.
What does it tell you about the person's temperament toward borrowing? Conservative fellow doesn't believe in borrowing.
Then we'll invest our own money. Slow, sluggish, continuous growth.
This fellow comes to you. If you
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give me a one-year credit, I'll give you a large order. He doesn't believe in borrowing.
He'll probably not ask you, but if he does ask you, go right ahead. This fellow goes to a bank, doesn't go.
But if he goes to the bank, maybe you should roll out the red carpet to him. This fellow comes to you, buy my shares.
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Guys, don't touch this company. You'll probably make more money giving him a fixed deposit than you'll make on his shares.
How do you rate the third company? Operating leverage high operating fixed costs more.
Break even on operations late.
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Once they break even, they will start enjoying the benefit of leverage. And then you see the next column.
What do you see? A low financial leverage low.
What does it tell you about this person's temperament toward borrowing? I will not call this company conservative.
I'd rather use the adjective sensible.
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leverage analysis told this person you don't borrow because if you borrow you'll become like the first company and this person has taken a conscious decision that my operating leverages are high and the only way I can offset the risk of high operating leverages is by
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keeping my financial leverages under check and therefore they will enjoy the benefit of leverage and still not become a very risky proposition. And how do you rate the last organization?
Operating leverage is low. Operating fixed costs less.
Those fixed costs over which you
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have no control are less. Lucky organization.
Even in tough days break even is not an issue. They break even on 10 12 15% of installed capacity utilization.
Early break even long way to travel before they touch full capacity. And then you look at the next
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column. What do you see?
A high. This company says of course I will use my money but in addition to my money I will also use a generous dose of borrowed money and nevertheless I'll not become a very risky proposition because the risk that financial leverages brings with it
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has been largely offset by the safety of operating leverages and therefore in my opinion probably the finest combination to possess. So folks, how do you how do you read the first company?
This organization should not have borrowed but they
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borrowed. How do you read the second company?
Second organization should have borrowed but they did not borrow. The third organization should not have borrowed and they did not borrow.
And the fourth one should have borrowed and
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they did borrow and therefore they enjoying the benefits of that.