Enterprise Risk and Microeconomic Leverage

Author: Cui Yi, Shao Xijuan, Dong Yongmin, et al
Publisher:
Publish Date: 2006-01-01
Features:
8.1.4 Suggestions for the Effective Use of Financial Leverage by Company Decision-Makers
With China's entry into the WTO, further deepening of reforms, and gradual improvement of the capital market, the first four points mentioned in the previous analysis of reasons will be improved. Therefore, this section focuses on providing some suggestions to enhance the decision-makers' ability to use financial leverage. The purpose is to strengthen company managers' identification of leverage and understanding of its effects; to grasp the relationship between leverage, company structure, and decision-making; and to fully utilize leverage's predictive and risk control functions to improve the company's profitability and its ability to monitor and prevent risks.
(1) Company decision-makers should understand the identification of leverage and its simple calculation.
(2) Company decision-makers should learn to use leverage to predict the range of profit changes and understand the company's sensitivity to sales revenue changes caused by internal and external environmental changes.
(3) Company decision-makers should learn to use leverage to analyze the opportunities and risks their company faces and control risks by selecting leverage values and adjusting leverage levels. Based on external macro environments, market competitive environments, and internal personnel environments and product portfolios, make as accurate an estimate as possible of sales revenue during the forecast period—the likelihood of worst-case and best-case scenarios and the extent of sales revenue changes under these scenarios. Then, using leverage's predictive function, first predict the impact of various scenarios on after-tax profit, earnings per share (or after-tax return on equity), and then compare the company's ability to withstand the worst-case scenario. If the company can withstand it, it can maintain or increase the existing leverage level to fully leverage the effect and seek leverage gains. If it cannot, it should reduce (or adjust) leverage to avoid risks. Generally speaking, compared to operating leverage, financial leverage is relatively easier to adjust. We do not encourage blind "four ounces displacing a thousand pounds," but we hope that the company's management can first use leverage knowledge to predict risks and opportunities, then assess the company's risk-bearing capacity, and in cases where it can be tolerated, seize opportunities and fully leverage the amplifying effect to purposefully "four ounces displacing a thousand pounds."
(4) The company's investment and financing decisions, (asset, financial) structure, (operating, financial) leverage, risk, and returns are closely related. Company decision-makers must fully understand and apply the interactive relationships between them to improve decision-making levels.
Operating leverage, financial leverage, and total leverage, as important components of financial theory, are often strictly constrained by theoretical conditions in their practical application. The mechanism of operating leverage only emphasizes how changes in sales volume within a certain production and sales range affect the impact of unit fixed costs on EBIT (Earnings Before Interest and Taxes), including the favorable effects of positive leverage and the adverse effects of negative leverage. Other factors, such as sales price, unit variable costs, and fixed costs, are assumed to remain unchanged at the current level. In reality, the sales price and unit variable costs do not necessarily remain constant with changes in sales volume. Companies may adopt strategies such as price reductions for promotional purposes; when production and sales volume increase to a certain