Need to Understand Financial Leverage

Financial leverage is the use of fixed-cost funds (debt, preference shares) in the capital structure so that a change in EBIT produces a larger change in EPS or return on equity. Degree of financial leverage:

$\text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest}}$

Why it is necessary to understand it

1. Capital structure decisions: managers must judge how much debt to use.
2. Risk assessment: fixed interest must be paid whatever the profit, so leverage raises financial risk and the chance of insolvency.
3. Return enhancement: if the return on assets exceeds the after-tax cost of debt, shareholders gain (trading on equity).
4. Tax benefit: interest is tax deductible.
5. Lending and investment: banks and investors use it to judge a firm's riskiness.

Impact on returns (illustration). Capital Rs 10,00,000; tax 30%. Plan A is all equity (10,000 shares of Rs 100). Plan B is 50% debt at 12% (interest Rs 60,000) and 5,000 shares.

At EBIT Rs 2,00,000, DFL of Plan B = 2,00,000 / 1,40,000 = 1.43. Leverage raises EPS by 40% because the after-tax return on assets (14%) exceeds the after-tax cost of debt (8.4%). When EBIT falls to Rs 60,000, interest consumes all the profit and EPS drops to zero, while the unlevered firm still earns Rs 4.20.

Conclusion: financial leverage magnifies gains and losses. It helps only when earnings are stable and the return on assets exceeds the cost of debt, so its concept must be understood before choosing a financing mix.

Standard Financial Ratios Used for Project Performance Measurement

Financial ratios are used to assess a project's profitability, liquidity, solvency, activity (efficiency), and debt-servicing capacity. Below, each ratio is explained with its formula and illustrated using hypothetical data of a project.

Hypothetical Financial Data

Project "X" — Annual Financial Data (Rs '000)

Derivation of EBIT: $\text{EBIT} = \text{Sales} - \text{COGS} - \text{Operating expenses} - \text{Depreciation} = 5{,}000 - 3{,}000 - 800 - 200 = 1{,}000$ Equivalently, $\text{EBIT} = \text{NPAT} + \text{Tax} + \text{Interest} = 490 + 210 + 300 = 1{,}000$

1. Profitability Ratios

a) Gross Profit Margin $= \frac{\text{Sales} - \text{COGS}}{\text{Sales}} \times 100 = \frac{5{,}000 - 3{,}000}{5{,}000} \times 100 = 40\%$

b) Net Profit Margin $= \frac{\text{Net Profit After Tax}}{\text{Sales}} \times 100 = \frac{490}{5{,}000} \times 100 = 9.8\%$

c) Return on Investment (ROI) / Return on Assets $= \frac{\text{Net Profit After Tax}}{\text{Total Assets}} \times 100 = \frac{490}{5{,}000} \times 100 = 9.8\%$

d) Return on Equity (ROE) $= \frac{\text{Net Profit After Tax}}{\text{Total Equity}} \times 100 = \frac{490}{2{,}000} \times 100 = 24.5\%$

Interpretation: These ratios measure the project's earning capacity. A higher margin indicates better operational efficiency and returns to investors.

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2. Liquidity Ratios

a) Current Ratio $= \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{2{,}000}{1{,}000} = 2.0$

b) Quick (Acid-Test) Ratio $= \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} = \frac{2{,}000 - 600}{1{,}000} = 1.4$

Interpretation: A current ratio of 2:1 and quick ratio above 1:1 indicate the project can meet short-term obligations comfortably.

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3. Solvency / Leverage Ratios

a) Debt-to-Equity Ratio $= \frac{\text{Total Debt}}{\text{Total Equity}} = \frac{3{,}000}{2{,}000} = 1.5$

b) Debt-to-Total Assets Ratio $= \frac{\text{Total Debt}}{\text{Total Assets}} = \frac{3{,}000}{5{,}000} = 0.6 \text{ or } 60\%$

c) Interest Coverage Ratio $= \frac{\text{EBIT}}{\text{Interest}} = \frac{1{,}000}{300} = 3.33 \text{ times}$

Interpretation: These ratios show the project's long-term financial stability. A debt-equity ratio of 1.5:1 is acceptable; interest coverage above 2 times indicates the project can service its debt.

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4. Activity / Efficiency Ratios

a) Inventory Turnover $= \frac{\text{COGS}}{\text{Average Inventory}} = \frac{3{,}000}{600} = 5 \text{ times}$

b) Debtors Turnover (assuming debtors = Rs 500 '000) $= \frac{\text{Credit Sales}}{\text{Average Debtors}} = \frac{5{,}000}{500} = 10 \text{ times}$

c) Total Asset Turnover $= \frac{\text{Sales}}{\text{Total Assets}} = \frac{5{,}000}{5{,}000} = 1.0 \text{ time}$

Interpretation: These ratios measure how efficiently the project uses its assets to generate sales. Higher turnover means better utilization.

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5. Debt-Service Coverage Ratio (DSCR)

$= \frac{\text{Net Operating Income}}{\text{Total Debt Service}} = \frac{1{,}000}{1{,}000} = 1.0$

Interpretation: A DSCR of 1.0 means the project's operating income is just sufficient to cover its annual debt obligations, with no margin of safety — a warning sign for lenders. A DSCR of at least 1.2–1.5 is generally preferred.

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6. Net Present Value (NPV) and Internal Rate of Return (IRR) — Supporting Measures

Although not ratios in the strict sense, these are commonly used alongside ratios:

• NPV = Present value of cash inflows − Present value of cash outflows. If NPV > 0, the project is financially viable.
• IRR = Discount rate at which NPV = 0. If IRR > cost of capital (say 12%), the project is acceptable.

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Summary Table of Ratios and Results

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Conclusion

Financial ratios provide a systematic framework for evaluating a project's profitability, liquidity, solvency, efficiency, and debt-servicing ability. In the hypothetical case above, the project shows satisfactory profitability and liquidity, but its DSCR of 1.0 is below the acceptable benchmark, indicating no margin of safety in meeting annual debt obligations. Therefore, project managers and lenders should use these ratios collectively — not in isolation — to make informed decisions on project approval, monitoring, and corrective action.