Financial Leverage - Explained in Hindi - YouTube

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Namaskar, my name is Mukul and welcome to Asset Yogi.

In this video, we are going to discuss Financial Leverage.

This video is part of a series in which I am discussing Leverage.

In the first video, we understood the concept of Leverage,

then in the second video, we understood the calculation of Operating Leverage.

In this video we will understand the calculation of Financial Leverage.

If you haven't seen my first two videos

then I will recommend that you must watch those videos before watching this video.

Because in this video we will go a little bit in advance

and see the formula of Financial leverage.

How it is calculated?

and we will also look at Combined Leverage.

How do operating leverage and financial leverage have a combined effect?

So that's why I recommend that you first watch those two videos,

after that you come to this video.

So as always, you have to watch this video till the last

so that you can clear this whole concept.

Let's go straight to the black board.

So as we understood the concept of leverage in our first video.

let's recap it quickly,

Suppose you want to lift this weight,

We are taking support of this beam,

and here is the point at which this support is touching, this is Fulcrum.

So now here if you apply force, then this distance of the fulcrum

from the force, this is a small l.

Let's also assume that Leverage is less.

What will happen in lower leverage?

you will have to apply more force and even then you may not be able to lift the weight.

So remember, you will have to increase the force here,

or there may be another option that you can change the position of this Fulcrum.

So if you do not change this position then you will either have to apply

more force or you will not be able to take the sufficient output.

So in lower leverage, the effort is more and the output is less.

Now let's assume that we have shifted this fulcrum here.

So, this figured is formed.

now the distance between fulcrum and force,

this is big and I denoted it by letter L.

So when our leverage increases, we may have to reduce this force.

Maybe only half the force will have to be applied, it may be that we can get more output.

When leverage is increased, you have to apply less effort and you get more output.

Now I'm not going to go into this formula in much detail.

We are basically trying to understand the concept here.

So when we talk about the same concept in Finance.

So what is this lever in financial leverage? what is this leverage?

So in financial leverage, this is the Debt.

We call debt a lever,

if the more debt the company takes, the more we say that its financial leverage is high.

Let us understand this by calculation.

Let's take a case here,

let's say a company needs 600 crores to start business.

And it funds it's entire business with equity.

Some promoters have a share in it and some investors have put money.

some money is from Retained earnings.

So in total, the company is generating 600 crores from 100% equity only.

Debt is zero.

In such a case, we understand financial leverage once,

Let's say their income statement is 200 crore sales in the last year.

Means, the latest current financial year.

First of all we remove the variable cost,

So this is a variable cost of 40 crores.

Variable cost is directly proportional to sales.

Your variable cost increases by the increase in percentage of sales.

We saw this in the last video too.

If we minus the variable cost, then we get the contribution.

Out of the contributions we minus fixed cost then we get the Operating profit.

This EBIT Earning Before Interest Access becomes your Operating Profit.

Out of 80 crores, now the interest is zero in this case.

Because debt is also Zero, there is no loan on it.

So zero minus 80 crores out of which 80 crores remained.

So our Profit before Tax is also 80 crores.

If I assume tax is 30%, then we minus 24 crores as Tax.

So our Profit after Tax is 56 crores.

So what is Financial leverage?

Financial leverage is basically a relationship between Operating profit and Profit before Tax.

you want to see the effect because of your interest,

how interest is affecting your profits?

So we call this the Degree of Financial leverage.

so what is its formula?

%Change in PBT, so as much as your Profit before Tax changes,

you will divide the change by %Change in EBIT.

so you will divide your EBIT by the change.

So once we understand this,

and see that in year 2, let us assume that your sales increase by 20%.

So we want to see what effect it will have?

So let's say if your sales increase by 20% then it becomes 240 crores.

I just keep writing the difference in percentage.

So by delta I am denoting this.

So it's 240 crores, 20% is 40 crores here, then it is added in it.

The variable cost will also increase in the same proportion.

So your variable cost of 8 crores increased by 20%.

Contribution of 48 out of 240 so we get 192.

So, it has increase to 20% because it's in the same proportion.

Your fixed cost is going to be the same, because the fixed cost will not increase.

Meaning you are extracting 20% ​​more output from the same factory.

So it is zero percent, so basically zero difference in fixed cost.

Now operating profit is 80 out of 192 then you are left with 112 crores.

So what is the difference in operating profit?

basically, this difference is 32 crores, so it became 40%.

Now the interest is zero, then the difference is also zero.

Now profit before tax is 112. crores, then this is also the same here.

See different is all same because the interest is zero in this case.

Our tax has become 33.6%, profit after tax is 78.4 crores.

So the total difference between these three is same.

Because tax is being levied on the same percentage only.

So both profit before tax and profit after tax increased by 40 percent.

So now if we take the degree of financial leverage here

So we want to see the %change in PBT.

So this is our +40%, here I write +40% divided by %change in EBIT.

That too is 40%.

so how much is our degree of financial leverage, it is 1.

Now because the debt was zero here, that's why this degree of financial leverage is 1.

otherwise, when we will consider Debt it will be more.

And note one more thing,

this is the relationship we have worked out within EBIT and PBT.

So, in EBIT and PAT, the relationship will be same too.

So the profit after tax and our Earning per share will also have a similar difference

when we talk in percentage.

That is why you will see this formula in many places that instead of Profit Before Tax, EPS is also written.

Because when we are talking about percentage change, see here it is 40% and here also it is 40%.

And if you take out the profit after tax as per share still it will be 40%.

when we talk about the percentage.

So that's why this formula can be taken both in PBT and EPS.

You can take any of the two,

whichever is easily available with you.

So, here we understood the simple case when the debt is zero.

Now let's also look at another Case in which the funding is being done,

Equity is now taken only 200 crores.

And the company has taken a loan of 400 crores.

So 33% is just equity, 67% is the Loan.

Let's see what will happen here?

I have taken the same income statement.

Now let's see how much will be Degree of Financial Leverage.

we will take the same case, so our sales increase by maybe 20%.

So the sales increased by 20%, your variable cost also increased by 20%,

after that the contribution also increased by 20%, the fixed cost is your zero.

because it will be same.

So everything is the same till EBIT.

40% increased here,

Now the interest will be 40 crores.

Suppose this is a loan of 400 crores, it is taken at 10% interest per annum.

So, the interest for 1 year is 40 crores.

So it's going to be the same here even within year 2.

Because you have to pay the same amount of interest.

So here the difference will be zero.

How much is the profit before tax, so 40 crore out of 112 then it will be 72.

So what is the difference in profit before tax?

See here it is an 80 percent difference.

So, if we take out 30% of Tax, then our profit after tax will come to 50.4%

So there is the same difference between both of them.

We have to compare mainly here,

I will remove it here, I did that to explain.

We have to see this relationship mainly.

So, what will be our Degree of Financial leverage?

% change in PBT is 80%.

Divided by Plus 40%.

So it is 2 in this case.

so what does this 2 mean here?

that if EBIT increases by 20%, if it is plus 20%.

So our profit before tax first or we call it PAT

it's going to be the same, then it will increase to 40%.

it means this.

Here we are saying this 80% because we are basically comparing it with sales.

But if EBIT increases by 20% then our profit before tax will become 40%

because our degree of financial leverage is 2 here.

So, you can calculate the thing with another formula too.

Another formula for the degree of financial leverage is EBIT upon PBT Directly.

So here you can also consider the relationship between these two.

So here you will directly divide 80 crores by 40 crores,

then here also you will get answer 2.

So whatever information is given,

according to that you can do your own calculation.

So that's what we took out the degree of financial leverage.

As I told you earlier, we have to understand the degree of Combined leverage too.

What is Degree of Combined Leverage?

In that we have the degree of operating leverage that we saw in the previous video

will combine it.

What was the degree of Operating leverage?

In that, we understood the concept of contribution and EBIT.

what is the relationship between them?

So %Change in EBIT Divided by %Change in Sales.

Now the effect of contribution and sales is equal Because only 20% is change.

You can also write sales instead of contribution.

So if we calculate this then it becomes 40%.

Because our %Change in EBIT is 40%.

So here we write 40%.

Divided by 20%, %Change in sales is our 20%.

So here also you get answer 2.

Degree of Financial leverage, w have already seen that we have 2.

Then the degree of combined leverage that tells your total relationship,

From Sales to Profit after Tax.

We saw the relationship of EBIT and PBT it is DFL.

contribution of these two and the relation of EBIT became our DOL.

And this PBT, PBT and PAT are the same things.

We had already seen that 80% change is coming here and 80% is coming here too.

So what you can do is that the degree of combined leverage

will simply multiply the degree of operating leverage by the degree of financial leverage.

So your answer will come, i.e. 2 x 2 = 4.

Meaning that if the sales is plus 20%.

So our profit after tax has increased by 80%.

see how big is the impact here,

See here the sales are increased by only 40 crores i.e. plus 40 crores.

And see, the profit after tax here has increased by 80% directly.

Directly from 28 crores to 50.4 crores.

If we want to write the formula for Degree of Combined leverage.

So we will multiply DOL by DFL.

And in this your %Change in EBIT will be canceled up and down.

so what will be left here, degree of Combined leverage your %Change in EPS you will write above.

And what will be written below the %Change in Sales.

So we have seen that here we are doing direct relationship study

of profit after tax and sales.

Profit After Tax or EPS.

So, the difference of EPS and the difference of PAT is the same 80% in this case.

So, we understood the case of increase in Sales.

Now we also see a case when our sales decrease,

So what is its effect when a company's leverage is too high?

Let's talk about Case 3.

let's say Equity is the same 200 crores and our debt is 400 crores.

In this case we assume that our sales are getting -20%.

So from 200 crores our sales became -40 crores.

-20% to 160% crores.

Here we have written our difference - 20%.

If our variable cost will also become -20%, then we will make -32 crores here.

Contribution will also be our -20%.

fixed cost is going to be the same, so there will be zero difference.

EBIT i.e. operating profit is our 48 crores here.

80 out of 128,

So how much is it, see carefully here it is -40%.

So if sales were -20% then our EBIT will be -40%.

Basically it's a double edged sword.

When you take too much Debt and the market is not doing well.

So your operating profit falls as fast as it can grow.

So if the interest is fixed, then another effect of interest will also come.

So here the difference of interest is only 0.

48 crores minus 4 crores, so your PBT is 8 crores.

so now your Profit before Tax is -80%.

You will pay tax on this and here you will pay 30% tax i.e. 2.4 crores.

And 5.6 crores is your profit after tax,

it is directly - 80%.

Now in the last case, when our sales were plus 20%,

we saw a profit of 50.4 crores.

And if the sales become -20%, then your direct profit here is 5.6 crores.

So, see how much impact it has on it,

here your profit is directly 1/10,

So whenever the market is not doing well,

So your profit erodes very quickly because of financial leverage.

So here if we take the degree of financial leverage,

then we will directly take the %Change in PBT.

So, it is - 80% divided by we will do -40%

So this is also 2 in this case also.

and our degree of Combined leverage is 2 x 2 = 4 That's why

you minus this 20% - then it became directly -80%.

our Profit After Tax.

So if I summarize the financial leverage,

if the financial leverage of a company is high.

For example, Real estate companies take a very high Debt.

Buildings are built on loan

So in that case the solvency risk becomes high.

Solvency risk means the risk of getting Bankrupt increases.

see why I am saying this,

When the return on investment is high, then this company grows a lot.

Let us assume that the return on investment is 20% of the company.

The market is doing very well

and the bank has given this money on interest of 12%.

So here you are getting the benefit of plus 8% straight away.

Which you are making a direct profit of 8% by using bank money.

Whereas if the return on investment goes down

The same return on investment remains only at 6%.

and you still have to pay interest of 12 percent.

So you have a direct loss of -6%.

you will have to pay from your own pocket Your equity will start eroding.

Company can fold up quickly.

Chances of Bankruptcy may increase.

And in today's date the biggest problem with the Real estate company

because the debt is too much for them, the interest has to be paid.

If we talk about low financial leverage companies.

let's say there is a software company and they make products.

Initially, they cost a lot but they have not taken any Debt,

there is zero debt here or there is very less debt.

So, what will happen in such case?

If their Return on Investment is less,

generally, it is not so low in the service industry.

Still, we assume that the market is doing well,

the product they have made is not being sold so easily.

Assuming the Return on investment is only 6%.

But they will survive because they have not taken any loan.

Their Solvency risk is very low.

So for this reason, when the company takes high debt, their leverage increases.

In a good market, it grows very fast,

but when the market does not do well, the chances of bankruptcy increases.

Their solvency risk becomes very high.

And low Leverage company is basically neutral,

because it is not debt dependent

Even if their return on investment is low, it can easily survive.

So I think after watching this video you must have understood

the concept of financial leverage very well.

And you must have also understood that taking high debt

is risky and you can grow much better in a good market.

But it is prudent for you that you take the debt

at such a time and understand the timing of the market a little.

If the market is going bad then try to pay your debt as early as possible.

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