Part 2 – Lesson 17

Overview


Financial leverage is a measure of how much debt a company has on the balance sheet.  It is measured as Net Debt divided by EBITDA.  Operating leverage is a measure of how much incremental EBITDA or EBIT is earned for every dollar of revenue that is earned.  Both concepts are referenced very often by investors since it provides investors with a measure with which to judge underlying business risk.

You can think of leverage as a fulcrum, such as a see-saw.  If the pivot point of the see-saw is placed very close to the person trying to apply the force, then, it takes a whole lot more force to lift the person on the other end of the see-saw.  This is “low leverage” since it takes a large amount of force to create a certain output.  Instead, if the pivot point of the see-saw is placed further away from the person applying force, it becomes much easier to lift the person on the other side.  This is “high leverage” since it takes a small amount of force to create a certain output.

In low leverage companies, every unit change in revenue creates modest changes in the underlying EBITDA or net income.  While in high leverage companies, every unit change in revenue creates much larger changes in the underlying EBITDA or net income.

Whether low leverage or high leverage is preferable to investors is simply a matter of preference and risk tolerance.  Investors with higher risk tolerance than can endure higher volatility of results (and therefore higher volatility of stock price) may be more comfortable with higher leverage companies since the added leverage provides the opportunity to boost the equity returns over time.  Investors with low risk tolerance may prefer companies with low leverage (particularly low financial leverage) since low leverage companies have less volatility in their financial results (all else equal).

Financial Leverage


Financial Leverage = Net Debt / EBITDA

Financial leverage is expressed as a multiple of EBITDA similar to how EV / EBITDA is expressed as a multiple.  While there are no lines in the sand that determine what is high vs. low financial leverage, many investors would consider low leverage to be 1.5x or less, while high leverage may be considered 3.5x or more.  Different investors may have different interpretations on what they consider to be high vs. low financial leverage.

Let’s look at an example of how financial leverage impacts the operating results of a company over time.

Let’s review the takeaways from this analysis:

  1. In the low leverage scenario, we can see that the 25% revenue growth rates lead to 30%+ EPS growth rates, whereas the 20% revenue declines in 2022 and 2023 lead to 25% EPS declines. We have also shown the net debt / EBITDA ratio over time, which hovers around the 1.0x leverage range.  It is important to note that financial leverage can decline not just by paying down debt, but also by growing EBITDA.

  2. In the high leverage scenario, we can see that the EPS growth rates are much more volatile than the low leverage company. When revenue is growing 25%, Company B is growing their EPS at 40-50%, which is a substantially higher growth rate vs. the low leverage Company A.  However, when revenue declines in 2022 and 2023, the EPS declines of 30-34% are higher than the 25% declines in Company B.

  3. In the high leverage scenario, the net debt / EBITDA is mostly around the 4-5x range. You may notice that the leverage ratio bottoms at 3.2x in 2021 but then quickly increases to 5.0x by 2023.  Another feature of high leverage companies is that the overall leverage level is more sensitive to changes in EBITDA.  The EBITDA drops by $100mm in 2023 for both Company A and Company B.  The low-leverage Company A sees a 0.25x increase in its leverage ratio in 2023.  However, the high-leverage Company B sees a 1.0x increase in its leverage ratio in 2023.

Why do management teams choose high leverage vs. low leverage balance sheets?


Often, the leverage level employed by a company comes down to 1) the nature of the underlying business, 2) the risk tolerance of the management team, and 3) the interest rate environment.

A stable underlying business with regular cash flows can typically support higher financial leverage.  For example, a cable company has a stable underlying business as consumers value their broadband connection, so churn rates are very low.  Given the recurring revenue nature of the cable business, these companies can often support higher leverage levels (3-5x EBITDA).

However, companies that are tied to a commodity price often have very low leverage levels due to the volatility in their revenues.  Mining companies that are tied to the price of copper, iron ore, and other base metals can see large swings in their revenue year to year.  Due to the lack of visibility in the revenue, these types of companies cannot support high financial leverage.  Putting 5x EBITDA of leverage onto a mining company would be a recipe for disaster when the commodity price slumps.

Additionally, the risk tolerance of the management also influences the leverage level of the company.  Keep in mind that the cost of equity is almost always higher than the cost of debt.  Therefore, funding the company with all equity creates a higher discount rate for the company vs. using cheaper forms of debt financing.  Management teams that can tolerate the increased risk associated with higher financial leverage are attracted to the increased reward associated with having a lower discount rate.

Lastly, financial leverage is influenced by the prevailing interest rate environment.  During periods of low interest rates, management teams are incentivized to borrow more since the cost of debt capital is very low.  However, in a high interest rate environment, the hurdle for taking on expensive debt is much higher.

Operating Leverage and Incremental Margins


Operating leverage is typically framed in terms of “incremental margin” and can be defined by EBITDA, EBIT (operating income), or other profitability measures.

Incremental EBITDA Margin = Change in EBITDA / Change in Revenue

or

Incremental Operating Margin = Change in Operating Income / Change in Revenue

Incremental margin is a measure of how much incremental profits a company generates for each additional $1 of revenue generated.  The “incremental profits” can be measured with EBITDA, EBIT, net income, or cash flow.  For example, if Company A earns an incremental $100 in revenue and $60 flows through to EBITDA, then, the incremental EBITDA margin is 60%

Let’s calculate the incremental margins in the below examples:

Question 1 – Company A has revenue of $1000 in Year 1 and $2000 in Year 2.  The EBITDA is $500 in Year 1 and $600 in Year 2.  What is the incremental EBITDA margin?

Answer 1

Incremental margin = Change in EBITDA / Change in Revenue
Incremental margin = ($600 – $500) / ($2000 – $1000)
Incremental margin = $100 / $1000
Incremental margin = 10%

Question 2 – Company B has revenue of $500 in Year 1 and $800 in Year 2.  The EBIT is $100 in Year 1 and $200 in Year 2.  What is the incremental operating margin?

Answer 2

Incremental margin = Change in Operating Income / Change in Revenue
Incremental margin = ($200 – $100) / ($800 – $500)
Incremental margin = $100 / $300
Incremental margin = 33%

Question 3 – Company C has revenue of $100mm in Year 1 and $200mm in Year 2.  The FCF is $20mm in Year 1 and $100mm in Year 2.  What is the incremental FCF margin?

Answer 3

Incremental margin = Change in FCF / Change in Revenue
Incremental margin = ($100mm – $20mm) / ($200mm – $100mm)
Incremental margin = $80mm / $100mm
Incremental margin = 80%

What creates operating leverage and what is a “good” or “bad” incremental margin?


Operating leverage is created by the presence of fixed costs.  Fixed costs are costs of the business that do not change regardless of the revenue level.  For example, utilities, rent, and salaries (in the near-term) are all fixed costs of the business.  On the other hand, costs that must be incurred as revenue is realized is a variable cost.  For example, cost of goods sold, marketing costs, and shipping costs are all examples of variable costs.

By definition, the incremental margin should be equal to 100% less the variable cost of incremental revenue.  For example, if each additional dollar of revenue for a company has a 40% variable cost associated with it, then, the incremental margin is 60%.  In other words, the company only needs to spend 40 cents of additional variable cost for each incremental $1 of revenue, so the incremental profit is 60 cents.

Companies with high fixed cost structures generate high incremental margins, whereas companies with low fixed cost structures generally have lower incremental margins.  Keeping this in mind, it is not necessarily a good or bad thing for a company to be a high fixed cost business vs. a low fixed cost business.

However, what can be said is that investor sentiment will generally swing more violently on high incremental margin businesses.  When times are good and revenues are growing, investors love being invested in companies with high incremental margins, particularly when those incremental margins are higher than the existing margin level of the company.  For example, a company with 60% incremental EBITDA margins and with a current EBITDA margin of 30% should display strong EBITDA growth and EBITDA margin growth as long as revenues are growing.  However, investor sentiment can flip negatively very quickly if revenues were to decline for this business.

Similar to financial leverage, operating leverage creates faster growth on the upside and faster declines on the downside.