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Department of Management and Entrepreneurship

Faculty of Management and Finance


University of Ruhuna

Course Code BBA 1203


Course Title Financial Management
Course Coordinator Mr. Y.M.B.A. Manawansha
Submission Due on 31.01.2017
Type of Assignment Group Assignment

Title of the Assignment Impact of Financial Leverage on the EPS of the company

No. Name of the student Student Reg. Remarks


No.
1 K.P Supun MF/2012/3263
2 P.K.S. Maduranga MF/2012/3309
3 U.M.D. Asela MF/2012/3328
4 L.N.Sanjana MF/2012/3347
5 P.L.D.Lakshani MF/2012/3359
6 S.T. Warnasinha MF/2012/3450
7 G.H.M. Sirikumara MF/2012/3444
8 G.A Sameera MF/2012/3517
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Office use only :

Date Stamp

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Executive summary

The main objective of this study is to determine the relationship between financial leverage and

Earing per share, as well as evaluate the effect of financial leverage on EPS. Used financial

information of a company listed on Colombo Stock Exchange (CSE) for a period of 5 years from

2016-2012. Data were sourced from annual reports of selected firm. The study revealed that there

is significant relationship between financial leverage and firms EPS and that financial leverage

has significant effect on firms EPF. The study concludes that financial leverage is a better source

of finance than equity to firms when there is need to finance long-term projects. However, various

economic factors may have despicable effects on the profitability of Sri Lankan firm, as such the

use of debt financing in such firms may yield negative impact such as bankruptcy as well as low

firm value. The study therefore recommends that financial leverage be optimized by firms to aid

maximization of firms EPS.

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Contents

1. Introduction ............................................................................................................................. 4

2. Methodology............................................................................................................................ 5

2.1. Analysis and Interpretation .................................................................................................. 6

3. Analysis ................................................................................................................................... 8

3.1. Financial Highlights 2016 .................................................................................................... 8

3.2. Financial Highlights 2015 .................................................................................................. 10

3.3. Financial Highlights 2014 .................................................................................................. 11

3.4. Financial Highlights 2013 and 2012 .................................................................................. 12

4. Conclusion ............................................................................................................................. 13

5. Recommendations ................................................................................................................. 15

6. Reference ............................................................................................................................... 16

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1. Introduction

Financial leverage is a measure of how much firms use equity and debt to finance its assets. A

company can finance its investments by debt and equity. The company may also use preference

capital. The rate of interest on debt is fixed irrespective of the companys rate of return on assets.

The financial leverage employed by a company is intended to earn more on the fixed charges funds

than their costs. It has been claimed by many finance researchers that financial leverage is the top

most factor among the other factors that can affect the firms profitability. It comprises the capital

structure management concepts. Manager choice of making debt intensive or equity intensive

company that formulate the financing of the company assets leads to the concept of capital

structure formulation. It has been observed that most of the times managers of the company use

some extent of debt and some extent of equity to finance their assets. Therefore right choice of the

combination of debt and equity is very important for the manager of any company. Those

companies who dislike to borrow funds for the financing of their assets have to rely completely on

equity financing therefore they are free from any fixed amount of charges to pay which means

there is no financial leverage associated with that company. It is obligatory that every individual

organization have to give especial focus towards the most important questions of amount of

financial leverage, associated cost of capital and their impact on the firms profitability.

Mostly firms take money from lenders in order to increase sales volume which leads to higher

earnings, such money which company have taken from the lender show the financial leverage

associated with that company. Generally financial leverage is measured by the ratio of total debts

which company owe and total assets which a company own. Financial leverage ratio tells the extent

to which company has used borrowed money in order to finance its capital structure. If company

use more borrowed money in order to finance its capital structure. If company use more borrowed

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money than company have to pay more fixed cost associated with that money. If firm use less

amount of debt than have to pay less amount of fixed cost associated with that borrowed money.

Such fixed cost associated with the borrowed money is the cost of debt which is generally called

as interest amount. If firm borrowed more money from creditors than firm has to pay more amount

of cost of debt to the creditors which is called interest rate which leads to the less net income for

the firm which means lower profitability. In economic boom period, higher financial leverage

gives benefits to the firm but on the other hand, in economic recession this financial leverage have

adverse impact on firms profitability. It can cause cash flow problems in economic recession

period for the firm and firm might not be able to meet its interest charges. This could be happen

because there will be less sale volume in economic recession which make the firm unable to cover

the interest payments to the creditors.

2. Methodology

The aim of this study was to investigate the effect of financial leverage on power and energy sector

firms profitability which are registered on Colombo Stock Exchange. For this purpose only one

predicting variable, financial leverage was used in ordinary least square simple regression model

which was measured as the ratio of total debt, which includes short term and long term debts, to

total assets which include current assets and non-current assets. Dependent variable was

profitability which was measured as the ratio of net profit after tax to total assets also called return

on assets (ROA). Financial statements of Laugfs Gas PLC for the year 2012 through year 2016

were collected from online database.

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2.1. Analysis and Interpretation

This chapter deals with the data analysis and interpretation relating to impact of leverage and

earnings.

EBIT / EPS Analysis

The EBIT-EPS approach is a method of structuring the firm's capital structure by determining the

combination of finding sources that maximizes earnings per share (EPS) over the firm's expected

range of earnings before interest and taxes (EBIT). It examine the effects of various financing

alternatives through an EBIT-EPS analysis, which involves determining the point of indifference

EBIT at which the EPS is the same between two financing alternatives like equity financing or

mixed debt and equity financing.

EPS - Earnings per Share

This is the amount of income that the common stockholders are entitled to receive (per share of

stock owned). This income may be paid out in the form of dividends, retained and reinvested by

the company, or a combination of both. (It is pronounced EPS).

Degree of Financial Leverage

Financial Leverage measures how much earnings per share (and ROE) respond to changes in

EBIT. The degree of financial leverage (DFL) can be computed with the following formula

DFL = Percentage change in EPS/Percentage change in EBIT

If there is debt in the capital structure, the DFL varies for different ranges of EPS and EBIT.

Test of Hypotheses

Operating leverage has no significant influence on earnings of Laugfs Gas PLC.


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The expected value of financial and operating leverage has no significant influence on

earnings of Laugfs Gas PLC.

Sales have no significant influence on earnings.

Financial leverage (DFL) affect earnings per share (EPS)

Fundamental analysis uses the degree of financial leverage (DFL) to determine the sensitivity of a

company's earnings per share (EPS) when there is a change in its earnings before interest and taxes

(EBIT). When a company has a high DFL, it generally has high interest payments. The high level

of interest payments negatively affects EPS.

A higher DFL ratio means that the company's EPS is more volatile. For example, assume

hypothetical company ABC has EBIT of $50 million, an interest expense of $15 million and

outstanding shares of 50 million in its first year. Company ABC's resulting EPS is 70 cents, or

($50 million - $15 million) / (50 million).

In its second year, company ABC had EBIT of $200 million, an interest expense of $25 million

and outstanding shares of 50 million. Its resulting EPS is $3.50, or ($200 million - $25 million) /

(50 million). Company ABC's resulting DFL is 1.33 (400%/300%), or (($3.5 - $0.7)/$0.7) / (($200

million - $50 million)/$50 million). Therefore, if the company's EBIT increases or decreases by

1%, the DFL indicates its EPS increases or decreases by 1.33%.

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3. Analysis

3.1. Financial Highlights 2016

As per the above analysis Company has increased its debts during the year and due to that reason

Finance cost also has been increased drastically and it has effect to the profitability heavily in

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current year. Than the last 2 years time company has taken debts and invested in the Assets and

though this will led to increase finance cost heavily, the company will be getting good profitability

future years.

Interest cover which showing the huge drop current years that is showing the leverage increase

during the year and it has resulted to drop the EPS by 35% in the current year.

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3.2. Financial Highlights 2015

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As per the above analysis Company has increased its debts during the year and due to that reason

Finance cost also has been increased. But by looking at the current year figures it is clear that

company has only increased 26% of debts. But interest on total loan at the Balance Sheet date is

high due to previous year loans. Also it is evidenced by looking at the Interest cover figure. It has

been reduced but it has reduced 52% current year by comparing the last year 59%.

Normally when financial leverage increased it will effect to the EPS figure also. But here it will

resulted to reduce the increment rate of the EPS but it was low than the last year EPS increment.

3.3. Financial Highlights 2014

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As per the above analysis Company has increased its debts during the year and due to that reason

Finance cost also has been increased. Also it is evidenced by looking at the Interest cover figure.

It has been reduced drastically.

Normally when financial leverage increased it will effect to the EPS figure also. But here it will

resulted to reduce the increment rate of the EPS.

By taking debts company has invested in the Assets and this small decrease of EPS will increase

in future due to this investment. And it will result future earning ability of the company.

3.4. Financial Highlights 2013 and 2012

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4. Conclusion

Financial leverage can be best described as the ability of a firm to use fixed financial leverages to

magnify the effect of changes in EBIT on the firms to use fixed financial leverage to magnify the

effect of changes in EBIT on the firms earnings per share. DFL and EPS increases or decreases

with the corresponding increase or decrease in DFL with the fulfillment of main 2 criterias: one

being debt capital cheaper than equity capital and other being rate of return on investment

exceeding(after-tax) cost of debt. Greater operating leverage and financial leverage may lead to

greater variability in earnings and ultimately greater systematic risk for the firm.

Leverage in investment portfolios is a common result of portfolio construction techniques, with or

without derivatives. It has the potential to enhance risk and exposure. It is a useful tool to achieve

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the desired level of risk and exposure. It is a useful tool to achieve the desired level of risk in a

portfolio. But containing the amount of leverage is not a good way to control risk, because leverage

is a tool that can be used to increase or reduce risk. Leverage has to be monitored well to have an

accurate view of its impact on risk. All leverages has to be monitored even leverage embedded in

products and funds, but this is hard to achieve. Using leverage introduces (or magnifies) risks,

most of all liquidity risks, that have to control. These controls are operational measures needed to

monitor and modify aspects of liquidity, leverage and counter party risk. Using leverage in a

portfolio requires understanding of the limitations of risk model and the limited knowledge and

modeling of liquidity. It is wise to maintain a margin error for both these limitations.

Use of fixed cost bearing capital in the capital structure is termed as financial leverage. Such

capital, especially debt is cheaper than the equity as the cost of debt is generally lower than that of

equity and a tax advantage is attached with its use. In this circumstances, if total capital employed

remains constant, increase in financial leverage or use of debt implies that a relatively cheaper

source of fund replaces a source of fund having relatively higher cost. Now if company follows

this practice its net return will be attributable to the low base of equity share holders (lower base

being due to the increase in financial leverage). As a result it will lead to magnification of return

to the equity and thus EPS. But one should keep in mind that the same holds well in favorable

business environment where the company is able to earn a rate of return on investment being higher

than the cost of financing. So long this situation continues the return on equity or EPS will increase

with the increase in financial leverage. The excess the rate of return on investment over the fixed

rate of interest and preference dividend will go to the equity share holders. However during the

period of adversity when the company is not in a position to earn greater (at least equal) rate of

return than the cost of debt its return on equity and EPS, instead of increase will actually decrease,

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with increase in the financial leverage. As higher earnings would leading higher dividends,

Increase in the use of financial leverage increases the earnings per share and thus dividend per

share. Conversely decrease in the use of financial leverage decreases the earnings per share and

dividends per share. Keeping this theoretical background in view, it is my humble effort to draw

the attention of readers regarding subjectivity of this paper and its applicability into real corporate

practice.

5. Recommendations

Based on this assignment work, the researcher made the following recommendations: Corporate

financial decision makers (in large firms) should employ more of long-term-debt than equity in

their financial option. This is in line with the pecking order theory. Also firms are strongly advised

to always compare the marginal benefit of using long-term-debt to the marginal costs of long-term-

debt before concluding on using it in financing their operations. This is because as shown by this

work, long-term-debt has impact on firms value. Also, firms should ensure to use optimal level

of debt in their capital structure, as this will lead to optimum capital structure and thus

maximization in firms value.

Finally, traditional theory states that as a company gearing increases above zero, the weighted

average cost of capital (WACC) will fall initially, because of the higher proportion of lower cost

debt capital in the firms capital structure, but eventually increases when gearing gets above a

certain level because of the rising cost of equity which offsets the higher proportion of low cost

debt. The researcher advises companies to reduce their use of debt at the point where the weighted

average cost of capital begins to increase, thus making the firms value to fall.

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6. Reference

I.m Pandey financial management- vikas publishing house Khan and jainfinancial

management-tata mc graw hill B.chandrashekara, k. Ramachandra, d.s pratima- financial

management

https://www.cse.lk/home/company-info/LGL.N0000/financial

Deloof, M (2003). Does working Capital Management affect Profitability of Belgian firms?

Journal of Business Finance and Accountancy 30(3) and (4).

Emekekwue, P.E (2008). Corporate Financial Management. 5th Revised ed; Kinshasha:

African Bureau of Educational Sciences

Yahyaoui, M. (2002). Determination of optimal financial structure for Algerian public

economic institutions University of Mohammed Khudair Biskra, Journal of Human

Sciences, Third Issue, p 90

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