1. The principle

The leverage effect explains a company’s return on equity in terms of its return on capital employed and cost of debt.

In our approach, we considered the total amount of capital employed, including both equity and debt. This capital is invested in assets that form the company’s capital employed and that are intended to generate earnings, as follows:

All the capital provided by lenders and shareholders is used to finance all the uses of funds, i.e. the company’s capital employed. These uses of funds generate operating profit, which itself is apportioned between net financial expense (returns paid to debtholders) and net income attributable to shareholders.

If we compare a company’s return on equity with its return on capital employed (after tax to remain consistent), we note that the difference is due only to its financial structure, apart from non-recurring items and items specific to consolidated accounts, which we will deal with later on.

The leverage effect explains how it is possible for a company to deliver a return on equity exceeding the rate of return on all the capital invested in the business, i.e. its return on capital employed.

Readers should pause for a second to contemplate this corporate nirvana, which apparently consists in making more money than is actually generated by a company’s industrial and commercial activities.

The leverage effect works as follows. When a company raises debt and invests the funds it has borrowed in its industrial and commercial activities, it generates operating profit that normally exceeds the interest expense due on its borrowings. If this is not the case, it is not worth investing, as we shall see at the beginning of Section II of this book. So, the company generates a surplus consisting of the difference between the return on capital employed and the cost of debt related to the borrowing. This surplus is attributable to shareholders and is added to shareholders’ equity. The leverage effect of debt thus increases the return on equity. Hence its name.

Let’s consider a company with capital employed of 100, generating a return of 10% after tax, which is financed entirely by equity. Its return on capital employed and return on equity both stand at 10%.

If the same company finances 30 of its capital employed with debt at an interest rate of 4% after tax and the remainder with equity, its return on equity is:

When divided by shareholders’ equity of 70 (100 – 30), this yields a return on equity after tax of 12.6% (8.8/70), while the after-tax return on capital employed stands at 10%.

The borrowing of 30 that is invested in capital employed generates operating profit after tax of 3, which, after post-tax interest expense (1.2), is fully attributable for an amount of 1.8 to shareholders. This surplus amount (1.8) is added to operating profit generated by the equity-financed investments (70 × 10% = 7) to give net income of 7 + 1.8 = 8.8. The company’s return on equity now stands at 8.8/70 = 12.6%.

The leverage effect of debt thus increases the company’s return on equity by 2.6%, or the surplus generated (1.8) divided by shareholders’ equity (1.8/70 = 2.6).

But readers will surely have noticed the prerequisite for the return on equity to increase when the company raises additional debt, i.e. its ROCE must be higher than its cost of debt. Otherwise, the company borrows at a higher rate than the returns it generates by investing the borrowed funds in its capital employed. This gives rise to a deficit, which reduces the rate of return generated by the company’s equity. Its earnings decline, and the return on equity dips below its return on capital employed.

Let’s go back to our company and assume that its return on capital employed falls to 2% after tax. In this scenario, its return on equity is as follows:

When divided by shareholders’ equity of 70, this yields a return on equity after tax of 1.1% (0.8/70).

Once invested in tangible assets or working capital, the borrowing of 30 generates an operating profit after tax of 0.6 which, after deducting the 1.2 in interest charges, produces a deficit of 0.6 on the borrowed funds. This shortfall is thus deducted from net income, which will drop to 70 × 2% − 0.6 = 0.8.

The original return on capital employed of 2% is thus reduced by 0.6/70 = 0.9% to give a return on equity of 1.1% after tax.

2. Formulating an equation

Before we go any further, we need to clarify the impact of tax on this line of reasoning.

Tax reduces earnings. All revenues give rise to taxation and all charges serve to reduce the tax bite (provided that the company is profitable). Consequently, each line of the income statement can thus be regarded as giving rise to either tax expense or a theoretical tax credit, with the actual tax charge payable being the net amount of the tax expense and credits. We can thus calculate an operating profit figure net of tax, by simply multiplying the operating profit before tax by a factor of (1 – rate of corporate income tax).

As a result, we can ensure the consistency of our calculations. Throughout this chapter, we have worked on an after-tax basis for all the key profit indicators, i.e. operating profit, net financial expense and net income (note that our reasoning would have been identical had we worked on a pre-tax basis).

Let’s now formulate an equation encapsulating our conclusions. Net income is equal to the return on capital employed multiplied by shareholders’ equity plus a surplus (or deficit) arising on net debt, which is equal to the net debt multiplied by the difference between the after-tax return on capital employed and the after-tax cost of debt.

Translating this formula into a profitability rather than an earnings-based equation, we come up with the following:

or

The ratio of net debt to shareholders’ equity is called financial leverage or gearing.

The leverage effect can thus be expressed as follows:

Note that:

• the higher the company’s return on capital employed relative to the cost of debt (e.g. if ROCE increases to 16% in our example, return on equity rises to 16% × 5.1% = 21.1%); or

• the higher the company’s debt burden, the higher the leverage effect.

  Naturally, the leverage effect goes into reverse once:

• return on capital employed falls below the cost of debt;
• the cost of debt is poorly forecast or suddenly soars because the company’s debt carries a variable rate and interest rates are on the rise.

The leverage effect applies even when a company has negative net debt, i.e. when its short-term financial investments exceed the value of its debt. In such cases, return on equity equates to the average of return on equity and return on net short-term investments weighted by shareholders’ equity and net short-term investments. The leverage effect can thus be calculated in exactly the same way, with i corresponding instead to the after-tax rate of return on net short-term financial investments and D showing a negative value because net debt is negative.

For instance, let’s consider the case of Burberry in 2017. Its shareholders’ equity stood at £1673m and its net debt was a negative £684m, while its short-term financial investments yielded 0.3% after tax. Its return on capital employed after applying an average tax rate of 28% stood at 32.6% based on its operating profit of £448m.² R²eturn on equity thus stands at:

The reason for Burberry’s ROE being lower than its ROCE is clearly not that the group’s cost of debt is higher than its return on capital employed! To put things simply, Burberry is unable to secure returns on the financial markets for its surplus cash on a par with those generated by its manufacturing facilities. Consequently, it has to invest the funds at a rate below its return on capital employed, thus depressing its return on equity.

The following tables show trends in ROE and ROCE posted by various different sectors in Europe over the 2000–2017 period.

ROE FOR LISTED GROUPS (EUROPEAN GROUPS PER SECTOR)

The reader may notice that high rates of ROCE cannot be maintained indefinitely, as can be seen in the steel, oil and mining sectors. We’ll be looking at this again in Chapter 26.

Utilities and food retail have similar ROE at 10% but very dissimilar ROCE (5% and 8%, respectively). The explanation lies in the level of debt, which is generally high for utilities as it is a capital-intensive sector and lower in the aerospace & defence industries, which exhibit poorer visibility.

ROCE FOR LISTED GROUPS (EUROPEAN GROUPS PER SECTOR)

3. Calculating the leverage effect

(a) Presentation

To calculate the leverage effect and the return on equity, we recommend using the following table. The items needed for these calculations are listed below. We strongly recommend that readers use the data shown in the tables on pages 53 and 155.

• On the income statement:
  • sales (S);
  • profit before tax and non-recurring items (PBT);
  • financial expense net of financial income (FE);
  • operating profit (EBIT).
• On the balance sheet:
  • fixed assets (FA);
  • working capital (WC) comprising both operating and non-operating working capital;
  • capital employed, i.e. the sum of the two previous lines, alternatively the sum of the two following lines, since capital employed is financed by shareholders’ equity and debt (CE);
  • shareholders’ equity (E);
  • net debt encompassing all short-, medium- and long-term bank borrowings and debt less marketable securities, cash and equivalents (D).

LEVERAGE EFFECT (E.G. ARCELORMITTAL)

In practice, the analyst may prefer to use the actual rate based on the average taxation for the firm.

CALCULATIONS

RESULTS

4. Companies with negative capital employed

Companies with negative capital employed usually have high negative working capital exceeding the size of their net fixed assets. This phenomenon is prevalent in certain specific sectors (contract catering, food retailing, etc.) and this type of company typically posts a very high return on equity.

Consequently, return on capital employed needs to be calculated taking into account income from short-term financial investments (included in earnings) and the size of these investments (included in capital employed):

As a matter of fact, companies in this situation factor their financial income into the selling price of their products and services. Consequently, it would not make sense to calculate capital employed without taking short-term financial investments into account.

1. Limitations of book profitability indicators

Book-based return on capital employed figures are naturally of great interest to financial analysts and managers alike. That said, they have much more limited appeal from a financial standpoint. The leverage effect equation always stands up to analysis, although sometimes some anomalous results are produced. For instance, the cost of debt calculated as the ratio of financial expense net of financial income to balance sheet debt may be plainly too high or too low. This simply means that the net debt shown on the balance sheet does not reflect average debt over the year, that the company is in reality much more (or less) indebted or that its debt is subject to seasonal fluctuations.

Attempts may be made to overcome this type of problem by using average or restated figures, particularly for fixed assets and shareholders’ equity. But this approach is really feasible only for internal analysts with sufficient data at their disposal.

For managers of a business or a profit centre, return on capital employed is one of the key performance and profitability indicators, particularly with the emergence of economic profit indicators, which compare the return on capital employed with the weighted average cost of capital (see Chapter 27).

From a financial standpoint, however, book-based returns on capital employed and returns on equity hold very limited appeal. Since book returns are prepared from the accounts, they do not reflect risks. As such, book returns should not be used in isolation as an objective for the company because this will prompt managers to take extremely unwise decisions.

As we have seen, it is easy to boost book returns on equity by gearing up the balance sheet and harnessing the leverage effect. The risk of the company is also increased without being reflected in the accounting-based formula.

If a company’s book profitability is very high, shareholders require a lot less and will already have adjusted their valuation of shareholders’ equity, whose market value is thus much higher than its book value. If a company’s book profitability is very low, shareholders want much more and will already have marked down the market value of shareholders’ equity to well below its book value. ⁴

It is therefore essential to note that the book return on equity, return on capital employed and cost of debt do not reflect the rates of return required by shareholders, providers of funds or creditors, respectively. These returns cannot be considered as financial performance indicators because they do not take into account the two key concepts of risk and valuation. Instead, they belong to the domains of financial analysis and control.

2. Uses of the leverage effect

Characteristic of the 1960s, or present-day China in the steel industry, a strategy of “forging ahead regardless” is particularly well suited to periods of strong growth. This is a two-pronged strategy – high levels of capital expenditure in order to increase the size of industrial facilities, and low margins in order to win market share and ensure that industrial facilities are fully utilised. Obviously, return on capital employed is low (low margins and high capex), but the inevitable use of debt (the low margins lead to cash flows insufficient to finance the high capex) makes it possible to swell the return on equity through the leverage effect. Moreover, the real cost of debt is low or negative because of inflation. However, return on equity is very unstable and it may decline suddenly when the growth rate of the activity slows down. This was the strategy of Suntech, the Chinese world leader in solar panels, which enabled it to take a lion’s share of its market, or as a consultant would put it, to move down its experience curve, but which was also the source of its collapse in 2013.

The leverage effect sheds light on the origins of return on equity, i.e. whether it flows from operating performance (i.e. a good return on capital employed) or from a favourable financing structure harnessing the leverage effect. Our experience tells us that, in the long term, only an increasing return on capital employed guarantees a steady rise in a company’s return on equity.

As we shall see in Section IV, the leverage effect is not very useful in finance because it does not create any value except in two very special cases:

• in times of rising inflation, real interest rates (i.e. after inflation) are negative, thereby eroding the wealth of a company’s creditors who are repaid in a lender’s depreciating currency to the great benefit of the shareholders;
• when companies have a very heavy debt burden (e.g. following a leveraged buyout, see Chapter 46), which obliges management to ensure that they perform well so that the cash flows generated are sufficient to cover the heavy debt servicing costs. In this type of situation, the leverage effect gives management a very strong incentive to do well, because the price of failure would be very high.

Bibliography