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million EBIT. The business would have to have earned a 20.0 percent ROA rate in this situation. But since interest is deductible, the business needed to earn only 18.0 percent ROA to pay interest and to generate 15.0 percent ROE for its shareowners.

RETURN ON EQUITY (ROE)

The example business is organized as a corporation. The company’s shareowners invested money in the business for which they received shares of capital stock issued by the business. Keep in mind that the stockholders could have invested this money elsewhere. The business over the years retained a good amount of its annual net income instead of distributing all its annual net income as cash dividends to its stockholders.

The total owners’ equity capital of the business from both sources is $6.0 million. This amount includes the paid-in capital invested in the business by its stockholders and the cumulative amount of retained earnings.

Stockholders’ equity capital is at risk; the business may or DANGER!

may not be able to earn an adequate net income for its stockholders every year. For that matter, the company could go belly-up and into bankruptcy. In bankruptcy proceedings, stockholders are paid last, after all debts and liabilities are settled. There’s no promise that cash dividends will be paid to stockholders even if the business earns net income. The ROE

ratio does not consider what portion (if any) of the business’s annual net income was distributed as cash dividends. The entire net income figure is used to compute the ROE ratio.

In the example (see Figure 6.2), the company’s ROE was 15.0 percent for the year, which is not terrific but not too bad.

This comment raises a larger question regarding which yardstick is most relevant. Theoretically, the $6 million owners’

equity in the business could be pulled out and invested some-where else to earn a return on the best alternative investment.

Should the company’s ROE be compared with the rate of return that could be earned on a riskless and highly liquid investment such as short-term U.S. government securities?

Surely not. Everyone agrees that a company’s ROE should be compared with
comparable
investment alternatives that have the same risk and liquidity characteristics as stockholders’

equity.

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The rate of return on the most relevant alternative (the next best investment alternative) is called the
opportunity cost of capital.
To avoid a prolonged discussion, simply assume that the stockholders want the business to improve on its 15.0 percent ROE performance. This implies that their opportunity cost of capital is higher than 15.0 percent, at least in the minds of the stockholders. Of course, the company should maintain its ROE and do even better if possible. One reason for the business’s ROE being as good as it is that the company had a nice gain from financial leverage.

FINANCIAL LEVERAGE

Piling debt on top of equity capital is called
financial
leverage.
As stated at the beginning of the chapter, if you visualize equity capital as the fulcrum, then debt may be seen as the lever that serves to expand the total capital of a business.

For this reason, using debt is also called
trading on the equity.

The main advantage of debt is that a business has more capital to work with and is not limited to the amount of equity capital that a business can muster. The larger capital base can be used to crank out more sales, which should yield more profit. Of course, this assumes that the business can actually make profit from using its capital.

Using debt also has another important potential advantage. If a business borrows money at an interest rate that is lower than its ROA rate, it makes a
financial leverage gain.
The idea is to borrow at a relatively low rate, earn a relatively high rate, and keep the difference. In Figure 6.2, note that the company earns 18.0 percent ROA but paid only 7.5 percent interest on its borrowed capital. (The business has several loans and pays different interest rates on each loan; the 7.5

percent is its composite average interest rate.) You don’t have to be a rocket scientist to figure out that paying 7.5 percent for money and earning 18.0 percent on it is a good deal.

In the example, debt provides 40 percent of the capital invested in assets ($4 million of the total $10 million). Thus, 40 percent of the company’s EBIT is attributable to its debt capital ($1.8 million EBIT × 40% = $720,000). But the business paid only $300,000 interest expense for the use of the
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debt capital. Therefore its gain is the excess, or $420,000

($720,000 debt’s share of EBIT − $300,000 interest =

$420,000 financial leverage gain). Another way to compute the gain from financial leverage is to multiply the 10.5 percent
spread
between the 18.0 percent ROA earned by the business and its 7.5 percent interest rate times the amount of its debt (10.5% spread × $4 million debt = $420,000 financial leverage gain before income tax).

A financial leverage gain adds to the share of EBIT available for equity capital. Figure 6.3 illustrates the importance of the financial leverage gain in the company’s profit performance for the year. Using debt provides additional earnings for the equity investors in the business. The shareowners earn EBIT on their capital in the business and also get the overflow of EBIT on debt capital after paying interest. In the example, financial leverage gain contributes a good share of the earnings for shareowners, as shown in Figure 6.3. The financial leverage gain adds 39 percent on top of EBIT earned on equity capital ($420,000 financial leverage gain ÷ $1,080,000

EBIT on equity capital = 39%).

In analyzing profit performance, managers should separate two components of earnings before income tax: (1) the financial leverage gain and (2) the EBIT earned on owners’ equity capital. As shown in Figure 6.3, the company’s $1.5 million earnings before income tax consists of $420,000 financial debt percent

debt share

$1,800,000 EBIT × 40% of total capital = $ 720,000 of EBIT

($ 300,000) interest

financial

$ 420,000

leverage gain

equity percent

equity share

$1,800,000 EBIT × 60% of total capital = $1,080,000 of EBIT

earnings for equity

$1,500,000

before income tax

FIGURE 6.3
Components of earnings for equity.

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leverage gain plus the $1,080,000 pretax EBIT on equity capi-

tal. Therefore, a good part of the company’s pretax profit is sensitive to the interest rate on its debt and its ratio of debt to equity. If its interest rate had been 18.0 percent (an unreason-

ably high interest rate these days) the financial leverage gain would have been zero.

The business, by using a moderate amount of debt capital, enhanced the earnings for its owners. Professor Ron Melicher, my longtime colleague at the University of Colorado, calls this the
earnings multiplier effect.
I very much like this term to describe the effects of financial leverage. The financial lever-

age multiplier effect cuts both ways, however. A percentage drop in the company’s ROA causes earnings for equity to drop by a larger percentage.

Why not borrow to the hilt in order to maximize financial leverage gain? Well, for one thing, the amount of debt that can be borrowed is limited. Lenders will loan only so much money to a business, relative to its assets and its sales revenue and profit history. Once a business hits its borrowing capacity, more debt is either not available or interest rates and other lending terms become prohibitive. Furthermore, there are several disadvantages of debt.

The deeper lenders are into the business the more restric-

DANGER!

tions they impose on the business, such as limiting cash dividends to shareowners and insisting that the business maintain minimum cash balances. Lenders may demand TEAMFLY

more collateral for their loans as the debt load of a business increases. Also, there is the threat that the lender may not renew the loans. Some businesses end up too top-heavy with debt and can’t make their interest payments on time or pay their loans at maturity and the lender is not willing to renew the loan. These businesses may be forced into bankruptcy in an attempt to work out their debt problems.

In short, using debt capital has many risks. Interest rates change over time and the ROA rate earned by a business could plunge, even below its interest rate. Even relatively small changes in the ROA and interest rates can have a sub-

stantial impact on earnings. It’s no surprise that many busi-

nesses are quite debt-averse, opting for low levels of debt even though they could carry more. The company in the example uses a fair amount of debt; using either more or less debt would have caused more or less financial leverage gain.

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s

END POINT

Every business must decide on a blend of debt and equity capital to invest in the assets it needs to make a profit. The total capital invested in assets should be no more than necessary.

Interest has to be paid on debt capital, and the business should earn at least a satisfactory return on equity capital in order to survive and thrive. The starting point is to earn an adequate return on assets (ROA), that is, an adequate amount of earnings before interest and income tax (EBIT) relative to the total capital invested in assets. Operating liabilities (mainly accounts payable and accrued expenses payable) are deducted from total assets to determine the amount of capital invested in assets.

Using debt enlarges the total capital base of a business, and with more capital a business can make more sales and generate more profit. Using debt for part of the total capital invested in assets offers the opportunity to benefit from financial leverage—as well as the risk of suffering a financial leverage loss if the business does not earn an ROA rate greater than the interest rate on its debt. Managers should measure the financial leverage gain or loss component of earnings for shareowners.

The financial leverage gain or loss component of earnings is sensitive to changes in the interest rate, the debt level, and the ROA of the business.

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C H A P T E R 7

Capital Needs

of Growth

IIn this chapter we return to the business example introduced in Chapter 3 and whose external financial statements are interpreted in Chapter 4. The business’s financial performance for the year just ended was satisfactory at best. For instance, the business’s profit ratio on sales (bottom-line net income divided by sales revenue) was just 4.0 percent. Its lackluster profit ratio resulted in a return on equity (ROE) of only 12.0 percent. Its shareowners have made it clear that the business should do better than this.

Later chapters explain analysis tools and strategies for improving profit. This chapter starts with the profit improvement plan for the coming year that has been developed by the business. The chapter focuses on the additional amount of capital that the business will need to carry out its profit improvement plan. The main theme of the chapter is this:
Profit planning also requires capital planning.

Managers cannot simply assume that the needed capital will become available like manna from heaven. They should determine how much additional capital would be needed to support profit growth and they should plan for the sources of the new capital.

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PROFIT GROWTH PLAN

The business has developed an ambitious profit improvement plan for the coming year. Sales goals have been established for virtually every product the business sells. Sales pricing will be more aggressive. (The very important effects of changes in sales volume and sales price are examined in later chapters.) Advertising and sales promotion programs have been approved. Cost control will be a top priority in the coming year. To replace its old machines, equipment, tools, and vehicles the board of directors has approved a
capital expenditures
budget for the coming year. The business is optimistic that it can achieve its profit and return on equity goals for the coming year.

Figure 7.1 summarizes the company’s profit plan for the coming year. Actual results for the year just ended are shown for comparison, as well as the percent increases over the year just ended. Note that interest expense has a question mark after it. At this point the exact amount of debt for the coming year is not known. The business will need to increase its assets to support the higher sales level next year, which means it will need more capital to invest in its assets.

Some of the additional capital may come from increasing its debt—by borrowing more money from its lenders. Clearly, the amount of the business’s debt will not decrease given the planned increase in sales revenue. So the interest expense for the year just ended is carried forward for the coming year
Year Just

Coming

Ended

Year

Change

Sales revenue

$39,661,250

$45,857,625

+15.6%

Cost-of-goods-sold expense

$24,960,750

$28,589,255

+14.5%

Gross margin

$14,700,500

$17,268,370

+17.5%

Variable and fixed operating expenses

$11,466,135

$12,675,896

+10.6%

Earnings before interest and income tax

$ 3,234,365

$ 4,592,474

+42.0%

Interest expense

$

795,000

$

795,000
?
+ 0.0%