Sub-topic 4: Measures of Leverage and Risk
This module delves into the critical concepts of financial leverage and risk, essential for understanding a company's financial health and investment potential. We will explore various measures used to quantify these aspects, crucial for CFA candidates.
Understanding Financial Leverage
Financial leverage refers to the use of debt financing to increase the potential return on equity. While debt can amplify profits, it also amplifies losses and increases financial risk. Understanding how much debt a company uses is key to assessing its financial strategy.
Key Measures of Leverage
| Measure | Formula | Interpretation |
|---|---|---|
| Debt-to-Equity Ratio | Total Debt / Total Equity | Indicates the proportion of debt financing relative to equity financing. Higher ratios suggest greater leverage and risk. |
| Debt-to-Assets Ratio | Total Debt / Total Assets | Measures the percentage of a company's assets financed by debt. A higher ratio indicates more financial risk. |
| Interest Coverage Ratio (TIE) | EBIT / Interest Expense | Measures a company's ability to meet its interest obligations. A higher ratio indicates a greater ability to cover interest payments. |
| Fixed Charge Coverage Ratio | (EBIT + Lease Payments) / (Interest Expense + Lease Payments) | A broader measure than TIE, including other fixed obligations like lease payments. Higher ratios indicate better ability to cover all fixed charges. |
Understanding Financial Risk
Financial risk is the additional risk placed on the common shareholder as a result of the decision to finance with debt. It's directly related to leverage. The higher the leverage, the higher the financial risk.
Degree of Financial Leverage (DFL)
The Degree of Financial Leverage (DFL) quantifies the sensitivity of earnings per share (EPS) to a change in earnings before interest and taxes (EBIT). It tells us how much EPS will change for a 1% change in EBIT.
The Degree of Financial Leverage (DFL) is calculated as: DFL = % Change in EPS / % Change in EBIT. Alternatively, DFL = EBIT / (EBIT - Interest Expense). A DFL of 2 means that a 10% increase in EBIT will lead to a 20% increase in EPS, assuming all other factors remain constant. This highlights the amplifying effect of debt on shareholder returns.
Text-based content
Library pages focus on text content
A higher DFL indicates greater sensitivity of EPS to changes in EBIT, meaning higher financial risk.
Total Leverage
Total leverage combines the effects of operating leverage and financial leverage. Operating leverage relates to the proportion of fixed operating costs in a company's cost structure, while financial leverage relates to the proportion of debt in its capital structure.
A high Debt-to-Equity ratio generally indicates higher financial leverage and thus higher financial risk.
DFL = % Change in EPS / % Change in EBIT, or DFL = EBIT / (EBIT - Interest Expense).
Risk and Return Trade-off
The concepts of leverage and risk are intrinsically linked to the fundamental principle of the risk-return trade-off. Investors expect higher returns for taking on higher levels of risk. By understanding leverage, analysts can better assess the risk premium required for an investment.
Higher leverage leads to higher potential returns but also significantly increases the risk of financial distress and bankruptcy.
Learning Resources
Official curriculum material from the CFA Institute covering financial leverage, essential for exam preparation.
A comprehensive explanation of financial leverage and its importance, including key ratios and their interpretations.
Detailed explanation of the Degree of Financial Leverage (DFL) with formulas and practical examples.
Advanced concepts in financial risk management, building upon the foundational understanding of leverage.
An introductory video explaining the concepts of leverage and its impact on financial risk.
A guide to various leverage ratios, their calculation, and what they signify for a company's financial health.
Explains the Interest Coverage Ratio (TIE), a key metric for assessing a company's ability to service its debt.
Covers the Degree of Total Leverage (DTL), which combines operating and financial leverage effects.
Explains the fundamental concept of the risk-return trade-off in finance, directly relevant to leverage decisions.
A lecture from a Coursera course on financial statement analysis, focusing on the role of leverage.