Treasury Inflation-Protected Securities (TIPS)
Investors who hold bonds generally earn a fixed nominal rate of return. However, the nominal return that they earn is in turn composed of two parts. One part compensates the investors for the inflation which has increased in the external world while their money has been locked in the security. The second part is the […]
Retirement Basics: Roth IRA
Roth Individual Retirement Account (IRA) is a retirement account that has been named after Senator Roth, who played an instrumental role in bringing this retirement account into existence. The Roth IRA is the second most popular investment vehicle used in the United States of America, the first one being 401(k). The popularity of the Roth […]
Financial Intermediaries – Meaning, Role and Its Importance
Introduction A financial intermediary is a firm or an institution that acts an intermediary between a provider of service and the consumer. It is the institution or individual that is in between two or more parties in a financial context. In theoretical terms, a financial intermediary channels savings into investments. Financial intermediaries exist for profit […]
The Impact of Shrinkage on Finance in the Retail Industry
The retail industry is unique in many ways. There are several financial and operational concepts which are more relevant to the retail industry than to other industries. Shrinkage is one such concept which has more relevance in accounting for the retail industry. In this article, we will have a closer look at the concept of […]
The Stages of Descent into Bankruptcy
Bankruptcy is a common phenomenon in the business world. There have been many cases wherein the stalwarts of yesterday, the companies which were running multi-billion dollar profits, have later filed for insolvency. For the benefit of the readers, let us define bankruptcy. Bankruptcy is the stage at which companies find it financially unviable to function. […]
A high debt equity ratio makes the company financed by debt more than by equity. Therefore there are fixed interest payments involved. Hence when the going is good, the company makes a handsome return as a small percentage of change in EBIT creates a large percentage change in earnings per share. However the inverse of this is also true. Just like financial leverage helps to magnify profits, it also magnifies losses when EBIT fall down. Analysts want to quantify exactly how much variability does debt funding create in the operations of a particular company and have created a measure called “Degree of Financial Leverage” which we will study in detail.
Degree of Financial Leverage = % Change in EPS / % Change in EPS
There is a reasonable assumption about the absence of any changes in accounting policy which would make the EPS and EBIT figures incomparable from the previous years.
Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Lets say that the price of the house went up by 20% to 120. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 43. Since your original investment was Rs 30, you have gained Rs 13.
A price increase of 20% has led to an increase in the shareholders return by approximately 43%!
Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Lets say that the price of the house went down by 20% to Rs 80. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 3. Since your original investment was Rs 30, you have lost Rs 27.
A price decrease of 20% has led to a decrease in the shareholders return by approximately 90%
Leverage is very dangerous unless the company is reasonably certain of its earnings. Investors view the leverage ratio with great detail. This is because it enables a small change in the EBIT to completely wipe out the company’s capital and make it insolvent almost overnight.
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