To finance its operations, a corporation raises capital by borrowing money or selling shares of company ownership to the public. A corporation can only remain viable if it generates sufficient earnings to offset the costs associated with its financing – after all, some of its revenue needs to be paid out to stockholders, bondholders and other creditors. Thus, the composition of a corporation's financing plans has a significant impact on how much operating income it needs to generate.
Corporate Financing and Financial Leverage
Corporations often leverage their assets by borrowing money to increase production and, by extension, earnings. Financial leverage comes from any capital issue that carries a fixed interest payment, such as bonds or preferred stock. Issuing common stock would not be considered a form of financial leverage, because the required return on equity (ROE) is not fixed and because dividend payments can be suspended, unlike the interest on loans.
One common formula for calculating financial leverage is called the degree of financial leverage (DFL). This formula reflects the proportional change in net income after a change in the corporation's capital structure. Changes in DFL can result from either a change in the total amount of debt or from a change in the interest rate paid on existing debt.
The accounting equation for DFL is either earnings before interest and taxes (EBIT) divided by earnings before tax, or earnings per share (EPS) divided by EBIT.
Profitability and Earnings Before Interest and Taxes
Earnings before interest and taxes measures all profits before taking out interest and tax payments. This isolates the capital structure and focuses solely on how well a company turns a profit.
EBIT is one of the most commonly used indicators for measuring a business's profitability and is often used interchangeably with "operating income." It does not take into consideration changes in the costs of capital. A corporation can only enjoy an operating profit after it pays its creditors, however. Even if earnings dip, the corporation still has interest payment obligations. A company with high EBIT can fall short of its break-even point if it is too leveraged. It would be a mistake to focus solely on EBIT without considering the financial leverage.
Rising interest costs increase the firm's break-even point. This won't show up in the EBIT figure itself – interest payments don't factor into operating income – but it affects the firm's overall profitability. It must record higher earnings to offset the extra capital costs.
Additionally, higher degrees of financial leverage tend to increase the volatility of the company's stock price. If the company has granted any stock options, the added volatility directly increases the expense associated with those options. This further damages the company's bottom line.