Question

Our text defines “financial leverage” and “financial risk”. Then it states “Debt finance does not affect operating risk but it does add financial risk.” Using these two terms explain why the statement is true and provide two specific examples.

Answer 1

Financial leverage is defined as the leverage a company gets when it uses debt financing. The positives of using debt financing and financial leverage is that the amount of interest costs on debt remain fixed. The amount of interest costs do not increase, even if the revenue/ EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation) generated is very high. Thus, when Revenue/EBITDA increases, a fixed amount is paid to debt holders as interest cost and the remaining may be passed on to equity shareholders/ re-invested as retained earnings.

However, here's the catch - using financial leverage (debt financing), the interest costs remain the same even if the Revenue/ EBIDA generated is very low. Debt payments are fixed obligations for the company and thus, may be risky in case the company in unable to generate sufficient EBITDA. This is where the 'risky' part of using debt arises.

Financial risk is based upon the financing decisions of an entity - when it uses debt/ equity and so on. Thus, this risky part of debt is one of the main components of financial risk faced by a company using leverage.

On the other hand, Operating risk is the risk a company faced due to its operations. Operation risk refers to factors such as demand for product, inflation etc. and does not include the risk a company faces due to its capital (financial) structure.

For example,

A Ltd. produces bi-cycles for all age groups. The company recently issued equity shares worth $1,000,000. A Ltd. does not have any debt in its capital structure. This financing was taken by the company in Financial year 2017-18 and the EBITDA of the company in that year was merely $20,000 due to very low demand in bi-cycles.

In this case, the A Ltd. faces Operating risk as the bi-cycles produced were in very low demand by the consumers. The company does NOT face any Financial risk as no amount of debt exists in the company's capital structure.

However, let's take a loot at the following situation:

A Ltd. produces bi-cycles for all age groups. The company recently issued debt worth $1,000,000 at an interest cost of 5%p.a. The company has Equity already existing in its capital structure. This financing was taken by the company in Financial year 2017-18 and the EBITDA of the company in that year was $40,000 due to moderate demand in bi-cycles.

In this case, the A Ltd. faces Financial risk as the company has fixed obligations to pay for, which is $50,000 of interest cost, whereas the company's EBITDA s only $40,000. This risk arising due to debt is know as Financial risk

In reality, companies faced operating (business) and financial risk all the time. However, as we have seen, with the above 2 examples, "Debt finance does not affect operating risk but does add financial risk". This is merely because the operating risk of a company depends upon other factors such as demand of the product and its operations and is not related to/ affected by debt financing.