Analysis of the Leverage

-> DEF LEVERAGE = D/E

D = Total liabilities (financial and non-financial).

(Corporate Strategy => D = only financial liabilities).

Analyze the trend over a short period (3-4 years);
Analyse the trend against a few competitors;

-> DEF: Ratio between the liabilities and the equity:

Find the right balance between liabilities and equity;
COMPANY IS LEVEREGING => is incrising the ROE & risk.

-> Company increase the debt by borrowing money to sustain the investment strategy to grow, buy equipement, invest R&D …

-> ⚠It is NOT reducing the equity or increasing dividends.

-> OBJ: understand how company has exploited the leverage (= financial resources collected by other stakeholders, shareholders and banks) to increase the profitability.

-> Leverage is proxy of decision about sources of founding:

Equity = ask money to sharehoders;
Borrow money from banks and bond holders = leverage.

-> IDEA: minimize the WACC (cost of capital)

Changing D/E => is changing WACC. Higher is D/E, higher is the risk: we are leveraging.

-> There are different approaches, we’ll see four:

DU PONT APPROACH (developed by top managers);
FINANCIAL ANALYST APPROACH (developed by financial auditing companies);
THEORETICAL APPROACH (developed by scholars of accounting);

_-> Companies are invited to leverage! INCREASE

Du Pont Approach:

-> IDEA: clarify the relation between the ROE and the D/E.

-> OBJ: find the mathematical relation to maximise the ROE.

Understand how create value;

-> It’s clear the view of the manager:

📌We’re still in accounting => The ratio leverage is between total liabilities / Equity (in Corporate Finance we’ll use Financial Liabilities/ Equity)

Total liabilities = financial + non financial liabilities.

4.We need to manipulate the formula in order to show the Revenues/equity ratio.

See that ROE is in function of NPM. They’re connected:

=> ROE 🔺 <=> 🔺 NPM

ATR = Revenues/Assets: isn’t a efficiency indicator (revenues are the output and assets are the input -> We want to maximise the output and minimize the input to be efficient.

NPM = Net Profit/ Revenues
- Net Profit: is decreasing
  - We’re increasing the financial debts => Financial Costs are increasing (more debts + banks see as more risky);

-> Taxes are decreasing true, but the net effect is that financial debts increase!

EBIT is decreasing:
- Depreciation (new assets should be depreciated) -> 🔻EBIT;
- Salaries might increase;
- Cost of materials (we might increase the production);
- Even with Industry 4.0 increase the costs of energy, supervisor and utilities.

=> We don’t know what is happening;

-> By levereging the company is able to increase the ROE =>

For this ratio is important to do a benchmark with more companies to understand the behaviour of the sector.
Increase the ratio by increasing the numerator or decreasing the denominator. We DO NOT consider the case in which we decrease the denominator (companies invest to increase the assets).
The leveraging math has a limit: the direct correlation between ROE and the leverage finish after a point.
Since Kd < Ke => better to leverage (risk capital is higher)

❓What happen if we leverage too much and too fast?

ATR DECREASE = Revenues / Assets.
- R at the beginning remain costant;
- A are growing (cash is increasing).

=> We are fat, have a lot of resources and revenues are not changing yet.

NPM DECREASE = Net Profit/Revenues:
- 🔺 Finacial expenses: company collect money from banks => D 🔺 and Kd 🔺 because it’s a function of ICR*
- Revenues aren’t chainging.
- 🔺 Depreciation;
- 🔻 EBIt

=> We could decrease the cost of labour. Investments could lead to higher cost of labour or automatization.

-> For in-depth study of theDu Pont Approach: Analisi ad indici section.

Financial Analyst Approach:

-> There are two approaches:

-> CHAR:

Used by a lots of auditing or consultancing (Ernst and Joung)
Understand the capability of the company to leverage: define the correct ration between liabilities and equitty in order to maximise the ROE;
ASSUMPTION: the assumption are impossible to applay (for this reason 2 approaches):
- Taxes are never = 0;
- Financial Income never = 0.

Leverage Analysis:

-> ASSUMPTION:

Tax rate = 0 -> Taxes = 0 (never true);
Financial Income = 0 (could only be for manufacturing companies);

=> Under these assumption Net Profit = EBIT – I (Financial Costs) = EBT

-> We want to isolate EBIT and Equity:

2.Interest Cover Ratio = Operating Profit (EBIT)/Financial Expenses

4.ROA and (1+D/E) are the axes off…

Consideration:

ROE is in function of the ROA => the prospective of the middle line manager is coherence with the expectation with the shareholders;
LEVERAGING too fast and too much:
- ROA 🔻 <= assets are increasing (growth strategy: company collect money from bank to buy new assets in order to generate EBIT) & EBIT decreases (more depreciation due to the presence of more assets, possible 🔺 labour costs).
- EBIT 🔻<= in short term, revenues remain as they are because we can’t see the effect of competitor’s CA on return.
- Cost <- Tipically increase the depretiacion because we have new assets;
- Salaries <- hire new people in order to run new machines;
- Same story.
- ICR 🔻 = EBIT /Financial Costs
  - EBIT 🔻
  - Financial Costs 🔺
1 – D/E : we got where then financial costs are higher than EBIT =>
- Operating activities are not able to support Financial Activities => EBIT is negative.

=> ROE might became negative => Company is not able anymore to generate profit to cover financial structure (short term).

-> If ROE < 0 => next year will be negative.

-> Tipically the startup

-> Remember the efficient matrix:

Real Life Version:

-> Can be applied in the deliverable, but is better to apply to Du Pont approach because it’s simpler and we get the same results.

-> ASSUMPTION:

Tax rate are not 0
Financial interests – financial income = net financial interest I*

-> DEFINITIONS:

Financial Interests – Financial Income = Net Financial Interests = I*

-> Compensiating financial cost because the financial income (for this net).

Net Profit = EBIT – I* – Taxes

-> ICR*: not correct definition, ICR*= EBIT/Net Financial Cost

Theoretical Approach:

-> CHAR:

Was developed in accademia environmental;
Shows relevant things;

-> ASSUMPTION:

Financial Interests – Financial Income = Net Financial Interests = EBIT – EBT = I*;

-> Consider Net Financial Interset from the real Annual Report. Is the difference between EBIT-EBT (From real AR)because consider all the financial interest.

Net Profit = EBIT – I* – Taxes

Tax rate are not 0.

-> We multiply by EBT to find:

s = Net Profit/EBT = Impact of Fiscal Activities.

Tells how much of EBT remains after taxes.
It’s conneceted to the tax rate;
Reflects the fiscal pressure in a specific country (is connected th teh geographical coverage);

-> s = 1 => taxes = 0 (never true, can consider only if we are intrested in financial part).

-> Net Profit vs EBT: Net Profit = EBT – Taxes => Net Profit / EBT tries to catch taxes!

-> Lower case s Ratio: how much EBT has been decreased, by taxes, in order to generate net profit (or how much we lose for taxes).

Not so relevant indicator (intermediate result);
Try to catch the impact of fiscal activities;
s = 1 – effect of tax rate;

3.We multiply EBIT for Assets/Assets to obtain ROA & I* times D/D because we sant to connect financial cost to liabilities.

We have an idea of the cost of the financial debts

-> We multiply the EBIT by assets and the I* multiplied by D (liabilities) => We get the ROA = EBIT/ASSETS

r = I*/D = Average Cost of Capital (not the WACC, is the average cost of the debt capital)

📌Kd and r are different (r can be consider a proxy of the cost of debt capital Kd).

Kd = financial interests/financial debt
r=I*/liabilities

-> if payables = 0, the denominators are almost the same. If the financial income = 0, the numerators are the same.

-> We can see the 3 most important activities in the IS:

Operating activities (ROA),
Financial activities (r),
Fiscal activities (s) + the leverage (D/E).

-> We can assume s = 1 because we are not that interested in the Fiscal pressure as it depends on the geographical coverage (beyond the company control), …

In case s = 1 –> ROE is produced by the ROA (same comment as the previous approach), so there is a connection between the perspective of the managers and the shareholders.

-> Coherence between activities run by middle line manager and senior manager: Middle Line: maximising the ROA => maximise the ROE;

The leverage is moderating the difference between (ROA – r) –>
- ROA measure the capability of the managers to make the most out of the assets they were given.
- r is a proxy of Kd, so of the cost of money.

-> IDEA company should have an high ROA able to cover r –> what matters is that ROA > r

So the what we generated with the money we used to buy the assets should be higher than the cost of the money. If this is not verified, the company is not able to generate money for the shareholders.

-> Company can increase ROE till ROA > r => Company can increase ROE until EBIT > Financial Cost;

-> Lower case R > ROA => part of the formula become negative and we destroy the capacity of company to create value.

Financial Cost: increasing because we are perceived as riskier from banks;
We need to verify is that ROI > WACC –> we need to consider also the remuneration of the shareholders (ROA > r is not enough). The company must compare the cost of the invested capital WACC and the return on the invested capital ROI. Same story of applying the residual income.

❓What happens if we increase D/E?

The fiscal impact s doesn’t change (tax rate does not change);
ROA will decrease for the things said before;
D/E increasing –> we are leveraging
(ROA – r)? if it is positive, there is an advantage to leverage. Since ROA decreases and r increases*, we should stop leveraging when ROA gets closer to r, because otherwise we would get a negative difference.

*r increases because Kd increases –> ICR increases.

⚠Formula is working only with ROA not with ROI!

❓If a company behaves differently from the assumptions?

Example: ROA and r are extremely different –> the company should leverage a lot more. We see that the leverage remains constant or even reducing the leverage. Why? Try to find an explanation. There is a temporal lag between ROA and r (ROA is defined at the end of the year, r at the beginning –> this could be due to the fact that competitors were bad, etc. so expectations were different from expected).

❓Why are companies not leveraging?

Managers do not know what to do with the leverage (no strategic plan) –> proof is that cash is too high;
Managers don’t care because they only care about ROI and WACC, so if they are close they will not leverage –> their only concern is to remunerate the shareholders;