The Leverage Factor by James Ardell - HTML preview

SECTION I: THE THEORY OF CAPITAL STRUCTURE 2 LEVERAGE

In a fundamentals based “bottom up” analysis system, the increase and acceleration of sales is paramount. The axiom, “nothing in business happens without a sale” appears self evident. However, capital structuralism often seems to deny the need for greater returns by focusing on risk, even to the exclusion of large, uneven streams of income that might upset “corporate equilibrium”. This friction between marketing strategy and absolute risk is reconciled by a strong adherence to the principles of leverage.

Capital structure analysis adjusts for both the amount and variability of sales by first evaluating operating income as a function of sales, and secondly, by choosing the amount of funding from several alternative sources based on the risk of this evaluation. Since it makes comparative choices from a macroeconomic perspective, capital structuralism is a “top down approach”; business risk and credit availability put restrictions on all available choices. For example, a choice to add a new product line may not come to immediate fruition for a company who pays high interest rates and has excessive debt on its balance sheet. While the ideas that generate high returns often come from a detailed marketing plan that forms a foundation for the business, the risks incurred by the plan are often imposed from above: government regulations, competitor’s actions, and the fluctuations inherent in a typical business cycle. The gist of capital structure analysis is to resolve this conflict between what can be produced and what will be produced, by reconciling risk with return. Accordingly, the tools to manage this resolution are encompassed by two distinct measurements: operating leverage and financial leverage. BUSINESS RISK

Operating leverage is one measure of business risk also known as economic risk. As an example, consider the attributes of farming. To stay in business, the farmer must be concerned about the cost of seed, irrigation, storage, and transportation. Demand for his or her crop is dependent on weather, foreign competition and the availability of substitutes. The variability of inputs (costs) and outputs (demand and quantity produced) form economic risk. High fluctuations in demand often cause large swings in the prices that a farmer can charge. When suppliers’ prices also vary, the double edged sword creates an environment of high business risk Without any idea of how much to pay vendors or how much to charge customers, planning must be totally contingent on the unexpected, an immediate barter-like negotiation where uncertainty prevails. Little growth will occur in such an environment because no investor wants to commit capital without confidence in a minimum return.

Many economists believe that business risk is a reflection of the level of technology in an industry. Because fixed costs must be paid regardless of the level of demand, higher fixed costs imply that more business risk is incurred. When competitive pressure demands that specific quality standards are met, those standards are an outgrowth of the level of technology required by the industry. Fixed assets that have long depreciable lives are very costly, but necessary to meet these competitive pressures. Consider for a moment, the shrink wrapping on a CD. Would a customer buy a hand wrapped CD when the industry standard is to wrap it “as tight as a drum”? Moreover, adding fixed costs to any operation raises the breakeven point for sales, even when the total cost is the same. Once the percentage of fixed costs is increased, more sales must be generated to cover them. However, when an operation has a higher proportion of fixed costs, and sales are adequate, more units of production will be spread among the same amount of costs; the result is a higher operating profit. This single kernel of corporate risk, affects all other elements in the chain: demand schedules, variability of income, the probability of default and the methods and sources of funding projects. FINANCIAL RISK

Financial leverage is one measure of financial risk, which is the risk incurred by a firm for its decision to use debt financing. Companies face a choice of funding projects with equity (retained earnings, common stock and preferred stock) or debt (bonds, bank loans, commercial paper). When deciding to increase the amount of debt, the firm increases the risk to existing shareholders because earnings become partially channeled toward creditors in the form of interest payments, and away from the potential for higher dividends; the variability of income is increased. In return, shareholders receive the possible reward of higher earnings on a per share basis because fewer shares will be outstanding when debt is used in place of equity. Consequently, the firm increases its chance of bankruptcy when it incurs more debt; it can default on interest payments if earnings are not high enough to cover them. This risk can be decomposed into two basic elements: 1. The amount of potential loss - the claims that creditors have on a firm. 2. The probability of loss - a complex interaction between sales, earnings, and liabilities that determines solvency. LEVERAGE: A DEFINITION

If the choice to take on debt sounds dire, the student/investor will turn this decision into a profit-making venture by determining the crucial difference between strategy and obligation. Firms that are obliged to increase financial leverage in order to cushion poor demand have radically different characteristics from those who optimize capital structure. In fact, many well-run firms lower their overall risk because of the choice to use more debt; the risk entailed by the cost of higher interest payments is much less than the probability of new cash-flow. Indeed, the “prime rate” is set low enough to attract the best customers without burdening them with worries of insolvency.

If we think of leverage as a proportion of two different components of the same risk, each seeking to balance the other, we can form a general definition. In physics, a small force applied at one point can balance or control a much larger force at another point. A child’s see-saw is the classic example of this principle: when a fifty pound child balances a two hundred pound adult and then jumps off, the adult drops with a thud. If we view the smaller force (the child’s weight) as the denominator of a ratio, and the larger force as the numerator, it is simple to observe how a change in one component affects the change in the other, depending on their relative amount of association. In a financial context, we speak of “leverage” when a smaller amount of one variable has a larger effect on the other. In mathematical terms, we put the “derived component” in the numerator, and the “source component” in the denominator, and determine the change in both. In our example, the child’s weight was the source component, which had an exaggerated effect (derived) on the adult’s weight.

In economics, we usually view leverage in terms of input and output, but in finance, we add the element of connotative risk: we look for other associations that the level of leverage may affect. For example, if we discover a “new” labor saving method in which two people can accomplish the same amount of work as twenty-two, the method undoubtedly has a lot of “leverage. Of course, leverage almost always exacts an inherent “cost” and in our example, the two laborers would at least have rising expectations about wages, if not actual demands. Secondly, since each remaining person is more responsible for total production, more risk is involved; losing one person may cut production in half. Therefore, leverage always implies some risk-return tradeoff, which needs to be identified. Leverage can only be increased if the risks have been fully vetted.

While there are other measures of risk besides leverage, few display the integration of risk and return better than the balance between financial and operating leverages. In fact, capital structure theory is founded upon this integration: behind every strategic decision, that changes the price of a stock, lays some thread of leverage. Each time that capital is allocated for any given project, ultimate profitability depends on leverage. BASIC RISKS AND PROPORTIONS

Wall Street does not like uncertainty. If there is one quality to cultivate in the world of finance it is consistency; when a market is coherent, the financial community can make plans around expectations and predictions. Leverage, however, implies volatility and it is when two different types of volatility are mixed that a level of return is derived. Cash, for example has almost zero volatility, and very little return when kept in that form. At the other extreme are certain commodities that can skyrocket overnight, only to leave a futures owner poorer a few weeks out. Operating leverage is conceptually measured as % Operating Income / %