Once a Pastor of a church and a Fund Manager of a Mutual Fund Company ‘kicked the bucket’ at the same time and they reached the doors of The Almighty together. On reaching there, the Fund Manager was checked into a very beautiful place, all nicely decorated with flowers, wine freely flowing and what not! On the other hand the Pastor was shifted to a very filthy and dimly lighted room. Pastor complained about this and argued that he had served in a Church and should be treated better than the Fund manager who was actually a gambler. The Manager replied promptly “Sir, we go by the results, when you prayed, the people slept. Whereas when that Fund Manager slept, all the people (who had invested their money) prayed!!
Jokes apart, this is actually what mostly happens in India. Investors are by and large uninformed, and they rely heavily on the expertise (read ‘experiment’) of the Fund Managers and investment advisors. Others who invest on their own without any advise or help, rely heavily on “intuition” or “past trends of the particular stock” and when both these fail, they fall prey to the “herd mentality”. It is indeed a very complicated job to exactly predict the exact movement of the stock market. This is because the prices are determined by different factors at different points of time, and some times there is a combined effect of different factors. These factors are micro-economic constraints, macro-economic constraints, government policy decisions, social, political or financial news, and last but not the least the herd mentality.
Each of these factors need to be deeply studied in order to find out how, and to what extent these factors affects the prices of shares of different companies. Being an informed investor by studying these factors, would certainly help in taking prudent decisions for maximization of their profits. Among these, the microeconomic constraints form the basic foundation on which prices are determined.
Given these constraints, the financial decision of the firm concerning the sources of financing and the construction of their capital structure has a considerable bearing on the shareholder’s wealth. Thus the way in which a company employs its resources in its assets or the way in which it raises money, either through debt or through dilution affects the shareholders risks as well as the returns. This effect is known as leverage. The leverage ratio is actually a combination of two types of leverages namely the operating leverage and the financial leverage.
The operating leverage is the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage exist when changes in revenue (sales) produce greater changes in the operating profit. It results from the existence of fixed operating expenses in the firm’s income statement.
When a firm has fixed operating costs, it’s likely that an increase in sales volume results in a more than proportionate increase in EBIT (Earnings before Interest and Tax). Similarly, a decrease in the level of sales has an exactly opposite effect. This is operating leverage; the former being favorable while the latter is unfavorable. Leverage thus works in both directions.
Operating leverage can be measured in quantitative terms and this is known as Degree of Operating Leverage (DOL). Symbolically,
DOL = Percentage change in EBIT divided by Percentage change in sales.
The greater the DOL, higher is the operating leverage. A higher operating leverage indicates higher risk as well as higher returns and vice versa.
The financial leverage on the other hand is the ability of the firm to use fixed costs of debts to magnify the effects of changes in EBIT on the earnings per share. In other words, financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Financial leverage can be more precisely expressed in terms of the degree of financial leverage (DFL). The DFL can be calculated as follows;
DFL= percentage change in EPS / Percentage change in EBIT (DFL > 1)
High fixed financial costs increase the financial leverage and thus financial risk. When the above two leverages are combined, we get combined leverage (DCL) and the risk associated with combined leverage is known as total risk.
DCL = DOL * DFL
Though this appears to be technical to a normal investor, still it is a very useful tool to measure the risk and return involved in investing the shares of a company. One needs to keep tap and be informed about these financial decisions being taken by the company management to ensure whether the DCL remains constant. If the DCL rises very steeply, it indicates that the risks involved have greatly increased and hence it might affect the market prices of its equity adversely. Similarly there are many other nuances that the investors need to study so that they pray only at the right place and right time !!
Prof. Jharna Lulla
Faculty Economics and Placement Officer
International School of Management Excellence
The author of the article is Prof. Jharna Lulla, faculty at International School of Management Excellence, Navi Mumbai. She has done her Masters in Economics and PGDM. She has extensive experience in Industry before moving to academics. Prof. Jharna is currently writing a book on Macro Economics and is a prolific writer in journals and magazines.