Evaluating the financial performance of a business includes looking at how its profit stacks up against the capital used by the business. Below figure presents Company A’s profit performance for the year down to the operating profit before interest and income tax. The profit report below is very condensed; it’s stripped down to bare essentials. It includes the five fundamental factors that drive profit performance. These key profit drivers are the following: (1) sales volume, or the total number of units sold during the period, (2) sales revenue per unit [sales price], (3) cost of goods sold expense per unit [product cost], (4) variable operating expenses per unit, (5) fixed operating expenses for the period.
Totals Per Unit
Sales volume, in units 120,000
Sales revenue $24,000,000 $200.00
Cost of goods sold expense $15,600,000 $130.00 (-)
Gross margin $8,400,000 $70.00
Variable operating expenses $3,600,000 $30.00 (-)
Contribution margin $4,800,000 $40.00
Fixed operating expenses $3,000,0000 $25.00 (-)
Operating profit $1,800,000 $15.00
The question is: Did the business earn enough operating profit relative to the capital it used to make this profit?
Next, suppose, purely hypothetically, that Company A used $100,000,000 capital to earn its $1,800,000 operating profit. In this situation, the business would have earned a measly 1.8 percent rate of return on the capital used to generate the profit:
= $1,800,000 operating profit / $100,000,000 capital
= 1.8 percent rate of return
By almost any standard, 1.8 percent is a dismal return on capital performance.
In general terms: the amount of capital a business uses equals its total assets minus its operating liabilities that don’t charge interest.
The main examples of non–interest bearing operating liabilities are accounts payable from purchases on credit and accrued expenses payable. Operating liabilities typically account for 20 percent or more or a business’s total assets. The remainder of its assets [total assets less total operating liabilities] is the amount of capital the business has to raise from two basic sources: borrowing money on the basis of interest-bearing debt instruments, and raising equity [ownership] capital from private or public sources.
Assume the following:
Company A’s Sources of Capital:
Owners’ equity $8,000,000 (+)
Total capital $12,000,000
Company A’s return on capital for the year is:
= $1,800,000 operating margin / $12,000,000 capital
= 15.0 percent return on capital
Company A’s interest expense for the year on its debt is $240,000. Deducting interest from the $1,800,000 operating profit earned by the business gives $1,560,000 profit before income tax. The rate of return on equity [before income tax] for the business is calculated as follows:
= $1,560,000 profit before income tax / $8,000,000 owners’ equity
= 19.5 percent return on equity
If Company A earned 15.0 percent return on capital [see the preceding calculation], but its return on equity is 19.5 percent.
The question is: Which is quite a bit higher. How do you explain the difference?
The higher rate of return on equity is due to a financial leverage gain for the year. Debt supplies 1/3 of the company’s capital [$4,000,000/$12,000,000 total capital = 1/3]. The business earned 15 percent return on its debt capital [$4,000,000 debt × 15 percent rate of return = $600,000 return on debt capital]. Because interest is a contractually fixed amount per period, the business had to pay only $240,000 interest for the use of its debt capital.
The excess of operating profit earned on debt capital over the amount of interest is called financial leverage gain. Company A made $360,000 financial leverage gain for the year [ it is $600,000 operating profit earned on debt capital – $240,000 interest paid on debt = $360,000 financial leverage gain].
The owners supply 2/3 of the total capital of the business, so their share of the $1,800,000 operating profit earned by the business equals $1,200,000 [$1,800,000 operating profit × 2/3 = $1,200,000 share of operating profit]. In addition, the owners pick up the $360,000 financial leverage gain. Therefore, the profit before income tax for owners equals $1,560,000 [$1,200,000 owners’ share of operating profit + $360,000 financial leverage gain = $1,560,000 profit before income tax]. The $1,560,000 profit before income tax yields the 19.5 percent on equity that triggered this question.
Financial leverage is a double-edged sword. Suppose, for example, that in the example scenario, Company A earned only $240,000 operating profit for the year. Interest is a contractual obligation that can’t be avoided. In this situation, all Company A’s operating profit would go to its debt holders, and profit after interest [before income tax] for its owners would be zero.
The business would have had a financial leverage loss that wiped out profit for its owners. When a business suffers an operating loss, the burden of interest expense compounds the felony and makes matters just that much worse for shareowners.