Evaluating the financial performance of a business includes analyzing the return on capital (how its profit stacks up against the capital) used by the business. The figure below presents Company A’s profit performance for the year down to the operating profit before interest and income tax. Did the business earn enough operating profit relative to the capital it used to make this profit?
Suppose, 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.
| Debt | $4,000,000 |
| Owners’ equity | $8,000,000 |
| Total capital | $12,000,000 |
Assume the following:
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. So, 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
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 ($600,000 operating profit earned on debt capital – $240,000 interest paid on debt = $360,000 financial leverage gain).
