For a company,
debt is an effective tool to raise funds for expansion and development
without diluting ownership control. Over exposure to equity for
financing capex could lead to a fall in earnings per share (

EPS
).

Debt, on the other hand, helps a firm enjoy the benefits of financial
leverage, which can also help improve the return on equity (ROE) for
shareholders.

Financial leverage entails use of borrowed funds to carry out expansions
with the expectation that the benefits in form of additional income
will exceed the cost of borrowing. The leverage is beneficial if the
return on investment(ROI) is greater than the cost of debt. If ROI is
less than the cost of debt, the financial leverage is unfavourable. If
ROI equals the cost of debt, the effects are neutral.
The following example explains financial leverage. Company A and Company B both employ capital of Rs 10 lakh each. Company A finances its capital entirely through equity whereas Company B uses 40% debt and 60% equity. The debt carries an interest rate of 10%. If both firms make an operating profit of Rs 2 lakh and pay tax at the rate of 30%, Company A’s ROE works out to 14% whereas company B’s will be 18.7%. The ROI of both companies is 20%, which is higher than the cost of debt of 10%. Therefore, financial leverage proves beneficial for Company B in improving ROE.

The debt-to-equity ratio is commonly used to get an idea of the financial leverage in a company. Another metric that helps to understand how efficiently a firm is using its financial leverage is called degree of financial leverage (DFL). It measures the sensitivity of EPS due to change in operating income and is calculated by dividing the percentage change in EPS by the percentage change in EBIT.

Another simple way of calculating DFL is by dividing EBIT by EBT. When there are no interest costs, DFL will have a value of 1. Therefore, a company will have financial leverage when its DFL is more than 1. For example, a company that has an EBIT of Rs 1 lakh with interest costs of Rs 25,000, will have an EBT of Rs 75,000. The DFL will work out to 1.33 which implies that EPS will change by 1.33% for every 1% change in EBIT. This means, if the EBIT is expected to go up by 20%, its EPS will go up by 26.6% (20%x 1.33). On the other hand, if EBIT is expected to contract by 18%, the EPS will fall by nearly 24%.

**Stocks with low DFL favoured by analysts**

*These stocks have delivered above average market returns and have the most buy recommendations from the analysts.*

*Data based on unaudited 2017-18 annual numbers. Stock price return is point to point absolute return between 31 March 2017 and 10 July 2018. BSE500 index delivered 17.5% returns. Source: ACE Equity & Bloomberg.*

The above example
shows that DFL imparts risk to companies that witness a decline in
operational income. Moreover, higher the DFL, higher the risk. Says B.
Gopkumar, Executive Director & CEO,

Reliance
Securities, “A high DFL is risky, if the operational performance does
not improve on expected lines. As interest cost is a fixed expenditure,
higher interest cost post leveraging will lead to higher deterioration
in EPS.”

High DFL also leads to stock price volatility. This is because EPS is a
critical input in estimating the fair value of a stock. The unaudited
data for 2017-18 for companies with a market cap of more than Rs 500
crore shows that stocks that had DFL more than twice the industry
average, significantly underperformed the market. There are 38 such
stocks and these stocks have delivered an average point to point returns
of 6.6% between 31 March 2017 and 10 July 2018. BSE500 index delivered
17.5% during the same time period. Comparatively, there are over 480
stocks that have DFL less than their industry average. These stocks
delivered point-to-point average returns of 38.4%.
The current macroeconomic conditions indicate a reversal in the interest rate cycle. A weakening rupee, rising inflation and surging bond yields are likely to create further pressure on RBI to increase interest rates. With interest rate tightening imminent, how should investors evaluate companies with high DFL? According to Axis Securities, “An increase in interest rates would result in an increase in interest expense and hence increase in DFL. In such a case, companies with high DFL should be seen from the perspective of earnings. It is important to check if the concerned company would be able to incur that extra cost through its operations or not. If they are still able to generate profits, then there should not be any concern."

“We believe net debt to EBITDA at 2-3 times for a company is considered to be good to go ahead for further capex. Any let up from this range mostly due to economic downturn is detrimental for the company,” says Gopkumar.

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