How Leverage Affects Business

Throughout the Covid-19 pandemic, investors have been worried about the future of the world economy and financial markets. In our “Evaluating News” article, we analyzed the difference between speculators and prudent investors. Whereas the markets let their fears or enthusiasm suggest prices for equities, you must form your own ideas on the value of potential holdings based on fundamentals.

Bear markets are a fact of life. It is hard to predict their outset and duration, but they’re a natural part of market cycles. Covid-19 seems to be a pretty big deal and will continue to affect the world economy for likely a few more months. While Wall Street and the markets have either been stalled or experienced extreme volatility, that doesn’t stop you from researching equities and learning new ways to evaluate their financials. Now is when you distinguish the ‘good businesses’ from the pack of firms that generally benefited from economic stability.

Leverage

Previously, our pieces on leveraged buyouts discussed how debt is used to buy companies. In this article, we’ll explore the concept of leverage in an operational context for businesses.

Leverage means borrowing capital (debt) to increase the potential return on an investment. As observed with leveraged buyouts, debt is used to acquire a company, with its cash flows and assets serving as collateral to secure and repay the borrowed amount. By using leverage to finance their assets, companies are able increase their buying power in the market. However, a rising junk bond market, over-levered firms, and mass bankruptcy slowed down the LBO boom of the 80s. A major takeaway from this article is that leverage always comes with a degree of risk.

Why Use Debt?

The capital structure of a company refers to the combination of debt and equity used for working capital or capital expenditure needs. Equity comes from selling common and preferred shares, while debt is obtained through bond issues or loans. Both equity and debt financing have a measurable cost of securing capital. With equity, this cost is the shareholders’ claim on earnings. Retained earnings is the amount of net income set aside for paying out dividends to shareholders, which is cut from a business’s bottom line. In addition, the appreciation of a company’s stock price is a type of ‘payment’ to shareholders for their investment. With debt financing, this cost is the interest expense on top of the principal amount of debt. The decision to take on more debt depends on the tradeoff between debt and equity, specifically the overall risk, costs, and profit potential.

Ex. Your small business is currently worth $200,000 and you need to finance $50,000. You have the option of a bank loan for $50,000 at 10%, or selling a 25% stake in your company to an investor. Qualitatively, a bank loan is easier to secure, and it isn’t certain whether you could find someone willing to invest in your business, let alone at a desired valuation. Quantitatively, debt financing would cost you $5000 in interest expenses, whereas equity would require no interest — but you could only keep 75% of your business’s profit. Suppose your business made $25,000 in net operating income the next year, then debt financing would leave you with $20,000, while equity financing would yield $18,750. Furthermore, you believe that your start-up could grow substantially in the next few years, so giving away equity right now could be unwise. Therefore, the cost and accessibility of debt financing can often outweigh that of equity.

Generally, shareholders do not want to assume all of the risk for funding a business. The more the capital structure is dependent on equity, the more likely a company will operate conservatively. Leverage can be advantageous because debt helps increase funding towards growth activities. Since shareholders aren’t liable for corporate debt so creditors assume default risk when issuing debt to a business.

Advanced Example of the Impact of Debt

A company has $1 million in assets (consisting of factories, machinery, equipment, cash reserves, etc.) which generate $100k in annual income. The return on assets (net income ÷ total assets) is 10%. If their assets are financed solely through equity, then the return on equity (net income ÷ average shareholder’s equity) is also 10% because there are technically no liabilities.

Now assume that assets and operations are funded with 500k of debt-financing (through loans or issuing corporate bonds) and 500k of equity (through selling primary shares). The capital structure is now 50/50. Consequently, debt needs to be paid back with interest every year. Let’s assume this cuts their net earnings to just $80k. As a result, the return on assets is 8% (80k ÷ 1 million). Return on equity is 16% because the amount of equity in the denominator has decreased by half (80k ÷ 500k).

Increased debt can benefit ROE when economic conditions and earnings are stable since half the risk of obtaining capital has been transferred to creditors.

Would you rather be a shareholder in the first scenario or second? With pure equity financing, potential growth is limited and shares are diluted when the company must keep issuing stock for capital needs. By balancing the capital structure with debt, there’s more room for growth.

However, the actual cost of debt decreases net income and ROA in this scenario because of smaller net earnings. But debt has the ability to boost ROA when a company uses it effectively. In the short term, debt yields interest expenses and a degree of future risk, but this is the tradeoff for its use towards capital investment.

Interest Expense as a Tax Shield

A tax shield is a reduction in taxable income as a result of allowable deductions such as interest, charitable donations, amortization, and depreciation. Interest payments are subtracted from gross earnings, and the taxable income is determined after all of the eligible expense deductions. Corporate taxes are a significant liability for businesses and take a great deal of operating income away from them. This is why companies often dedicate accounting departments, tax consultants, and lawyers to find ways to lower this bill. While debt financing still carries risks and expenses, it helps lower a firm’s overall tax bill. Hence, always carrying a bit of debt is useful.

Measuring Leverage

In finance, fundamental analysis is used to measure the performance of a company. In this section, we’ll go over different debt ratios and metrics derived from financial statements to analyze a firm’s degree of financial leverage. As we go along, we’ll use American Airlines Inc. and Delta Air Lines Inc. as examples because they belong to the same industry and they’re easy to compare.

Debt to EBITDA Ratio

EBITDA is earnings before interest, taxes, depreciation, and amortization. Debt to EBITDA ratio is an essential ratio because credit agencies use it extremely often. Some industries like oil and utilities are capital-intensive and need to carry a large debt load. This ratio determines how many years of EBITDA would it take to pay off all liabilities (short and long-term). A very high debt to EBITDA is usually 5x EBITDA, however, this varies across industries.

Debt to EBITDA = Debt ÷ EBITDA

This ratio compares the liabilities of a firm to the actual cash it generates to be able to pay them. EBITDA is used instead of net income because its a more accurate reflection of the actual cash flows used to pay debt and interest expenses. When applying this ratio, you ideally want to analyze the change in debt to EBITDA over the years.

Net Income is equal to operating income after interest and tax expenses. Since interest is a tax shield, EBIT or EBITDA is a better value to use in most leverage ratios because it represents the amount left that can be dedicated to debt payments. Also, we can’t just take revenues instead of EBITDA because companies have a lot of fixed operating expenses that need to be covered before debt allocations in order to generate sales.

Ex. A growing tech startup is $100 million in debt with an EBITDA of $10 million. The debt to EBITDA ratio is 10. In the next five years, as their EBITDA rises to $25 million, they reduce their total liabilities by half. Now, the ratio is 2.

A decrease in this ratio over time signifies that the business is gradually reducing its debt and/or earnings are increasing. A high debt to EBITDA could indicate a growth stage start-up or a high degree of capital investment.

Example: American Airlines & Delta Airlines

The airline business is capital intensive and requires a lot of short-term and long-term debt. Most of the expenses are fixed so airlines try to book out their planes to cover their costs and make as much profit.

A simple google search shows that both of these companies have brutally suffered because of international flight shutdowns. What’s worse is that they still have a lot of debt payments to cover. This is called operating leverage — when the majority of your expenses are fixed. When revenue declines, your bottom line is hit even harder.

Unlevered and Levered Free Cash Flow

Levered free cash flow (LFCF) is the amount of money a company has remaining after paying all of its debt obligations. LFCF is used for dividends to shareholders and investing back into the business. In other words, its the cash available to expand the business and pay returns to shareholders. A low LFCF means debt obligations cut more into a firm’s cash cushion. A higher LFCF indicates less risk for lenders because a business is able to lever up more comfortably. A negative LFCF means debt payments exceed operating cash flow, or substantial capital investments were made. As long as there is a good level of liquidity and cash reserves, a low LFCF isn’t too harmful.

Unlevered free cash flow (UFCF) is how much cash is available to the company before paying off debt obligations. It is net of capital expenditures and working capital needs, or the cash left to maintain and grow the firm’s asset base. UFCF is thus left over to pay debtholders and shareholders. It can be calculated as:

UFCF = EBITDA — CAPEX — Working Capital — Taxes

CAPEX (capital expenditures) represents investments in buildings, machines, equipment, and other fixed assets. Working capital (current assets — current liabilities) is basically operating liquidity — money used for day-to-day activities. After taxes, the remainder (UFCF) represents the gross free cash flow that is left for interest and debt repayment.

Subtracting UFCF and LFCF indicates how much debt a firm pays. If this difference is very great, the business may be overextended to meet obligations. Ultimately, you’d need to compare companies in the same industry to properly analyze free cash flow. This is a good metric for assessing debt because businesses fix the rate of their debt by paying it over a consistent period until maturity.

Example: American Airlines & Delta Airlines

American Airlines (AAL) has negative values and the difference between UFCF and LFCF is large. This isn’t a favourable situation, but if it's temporary, then it isn’t that bad. AAL can tap into current assets to pay its debt, but analyzing this metric over several years will show if this degree of financial leverage is unsustainable.

Delta’s UFCF is better than AAL’s, indicating that they don’t spend as much on debt currently. Nonetheless, the debt to EBITDA shows that Delta’s gearing of long-term debt is greater than AAL’s — suggesting LFCF will continue to rise. Both Delta’s and AAL’s negative LFCF demonstrates that the airline industry is probably more vulnerable to this economic recession because of their small cash cushions.

Debt Service Coverage Ratio

While multiples that use EBITDA measure interest, debt also includes a principal amount — the bulk of a loan. The total debt service of a business is the cash needed to pay the interest and principal on debt over a particular period (typically a year). The Debt Service Coverage Ratio is defined as net operating income divided by total debt service, where net operating income is revenue minus operating expenses.

DSCR = (Net Operating Income) ÷ (Total Debt Service)

If the value of this ratio is less than 1, that means the firm is earning less money than it is giving to creditors. Moreover, a value of 0.9 means the company’s net operating income can only cover 90% of the obligations for that period and must draw cash from other sources (ex. liquidating assets or borrowing more). This makes approval on new loans very difficult. Values that are higher suggest a greater capacity for debt and less risk for lenders.

Example: American Airlines & Delta Airlines

American Airlines has a value less than one. Again, if it's happening consistently, AAL is overleveraged. Instead of sinking earnings into an unmanageable level of debt, they can be allocated towards cash reserves, reinvestment in the business, or dividends.

While Delta may have a DSCR close to 2 (which seems healthy), their debt to EBITDA is still quite high. The implications of long-term debt on Delta must be considered as well. You can evaluate leverage ratios over the past 5 years and build a model for future earnings and free cash flow — which is a complex topic for another time.

Interest Coverage Ratio

The interest coverage ratio measures how a business can pay interest on its debt. It is calculated by dividing EBIT (earnings before interest and taxes) by total interest payments over a given period (quarterly or annually). This ratio is also called “times interest earned” because the value of the ratio shows how much times interest is earnings.

Interest Coverage Ratio = EBIT ÷ Interest Expense

Imagine a business with an interest coverage ratio of 1. That means they make exactly as much EBIT as their total interest expenses. Such a firm has a low earnings cushion for paying interest. Interest coverage below 1.5 shows that ⅔ of a company’s EBIT is going solely towards interest. As a lender or investor, this means they cannot feasibly take on more debt as the risk will continue to increase tremendously. Having a large margin of safety in earnings to pay interest is very important for survival, if and when, a company experiences sudden financial hardship and an earnings loss.

Conventionally, the interest coverage ratio should be analyzed on a quarterly basis over several years to show the trend in EBIT over interest. A stable trend is generally good because it shows the firm is able to maintain that level of debt and regular interest payments. A declining trend may suggest an overleveraged company as either EBIT is decreasing or more debt has been taken, increasing interest payments. Remember, the interest coverage ratio is an indicator of shorter-term leverage because total debt service is not exactly involved. Staying afloat with interest is essential to short-term operations.

Example: American Airlines & Delta Airlines

American Airlines designates a significant portion of their EBIT towards interest, compared to Delta. They’re historic interest and debt service shows an increasing debt expense over the years. This should, in theory, yield future growth. However, we now know that Covid-19 has negatively affected earnings because they can’t currently operate flights. An EBIT that is 2.74 times interest is the definition of a high degree of financial leverage because the return/risk is amplified when sales grow or decline. When revenues tank, debt payments don’t just go away unless a deferral agreement is made with creditors.

Delta’s ICR is surprisingly high, so you must investigate where else these earnings are going on the financial statements. In the future, their ICR will likely increase as long-term debt payments pile up. Delta may be in a safer position than AAL, but current economic conditions will for sure continue to impact its stock price.

These ratios show us that when the airline industry is hit with recession, they will perform exponentially worse. This is why Warren Buffet has continued to bash airline stocks, calling them “perennial money losers”.

Risk of Leverage

Debt is referred to as leverage because you borrow against future earnings and cash flow. A high level of debt and a sudden decline in operating income can result in missed payments, late fees, or default, which hurt a business’s creditworthiness. When debt is secured — meaning a business’s assets are used as collateral — failing to make payments causes asset foreclosure.

Lending institutions and bond investors use many of the aforementioned ratios before lending to a business. Obtaining more debt will come with a higher and riskier interest rate if a company already has a sizable amount of debt and unstable earnings. This severely limits future borrowing potential.

When debt becomes harder to secure, equity financing may seem more attractive. However, stock prices are based heavily on the company’s financial health and performance. An over-leveraged business is vulnerable to sales declines, risk of asset foreclosure/bankruptcy, and a lack of earnings for reinvestment and growth. Why would the stock market have faith in these types of companies? They aren’t worth the risk and likely won’t provide an adequate return-on-investment. Therefore, a high degree of financial leverage makes it harder to acquire both debt and equity financing.

I hope you gained a little insight into how leverage impacts businesses. Be sure to investigate this topic and leverage ratios more extensively to use them expertly in your portfolio decisions. More importantly, stay safe during this Covid-19 lockdown and practice social distancing + proper sanitation at all times. Also, look over some key takeaways and take the next steps to support us and further your learning!

Key Takeaways

1. Leverage means borrowing capital to increase potential return on investment
2. Capital structure is the combination of debt and equity to fund assets and working capital
3. Interest expenses are a tax shield
4. Debt to EBITDA shows how many years of EBITDA it will take to pay down all obligation
5. Levered Free Cash Flow is net of debt payments and Unlevered Free Cash Flow excludes debt
6. Debt service is the total debt payments (interest + principal) paid over a certain period
7. The interest coverage ratio shows how many times interest will give you EBIT
8. The risks of leverage are default, late fees, foreclosure, bankruptcy, etc.
9. A high degree of financial leverage hinders creditworthiness, future borrowing potential, and ability to obtain capital through debt and equity

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