Capital Structure and Leverage: Financial Leverage, EBIT–EPS Analysis (Basics)

Overview

Capital structure is about the mix of debt and equity used to finance the company. Leverage explains how fixed costs (fixed operating costs or fixed interest) can magnify the effect of changes in sales/EBIT on profits and EPS. EBIT–EPS analysis is a common exam tool to compare financing plans (more debt vs more equity) based on how EPS changes at different EBIT levels.

Learning objectives

You should be able to:

• Define capital structure and leverage.
• Classify types of leverage (operating, financial, combined).
• Explain financial leverage and how debt affects EPS.
• Explain the idea of EBIT–EPS analysis.
• Solve a simple EBIT–EPS comparison with a small table.
• Write merits/demerits of debt financing in points.

Meaning of capital structure

Capital structure is the proportion of long-term funds used by a company—mainly equity and debt (and sometimes preference capital) (concept).

Exam line: It is the long-term financing mix.

Capital structure vs financial structure (brief)

• Capital structure: long-term sources (equity, long-term debt, preference) (concept)
• Financial structure: includes both long-term and short-term sources (current liabilities etc.) (concept)

Meaning of leverage

Leverage means using fixed costs to increase the potential return to owners. Because fixed costs do not change with volume in the short run, small changes in sales/EBIT can cause larger changes in profits/EPS (concept).

Types of leverage (table)

Financial leverage: meaning and effect

Financial leverage arises when a company uses debt (fixed interest) in its capital structure.

Effect (concept):

• If return on investment is higher than debt cost, debt can increase EPS (benefit of leverage).
• If business performs poorly, fixed interest increases risk and can reduce EPS.

So financial leverage increases both return potential and risk.

EBIT–EPS analysis: meaning

EBIT–EPS analysis compares different financing plans by calculating EPS at different EBIT levels. It helps decide whether a debt-heavy plan or equity-heavy plan is better under expected EBIT (concept).

Simple EBIT–EPS comparison (mini example/table)

Assume two plans (concept):

• Plan A: all equity, no interest
• Plan B: some debt, fixed interest

At the same EBIT:

• Plan B may give higher EPS if interest burden is low relative to EBIT.
• But Plan B becomes risky if EBIT falls because interest is fixed.

Mini table idea (concept):

In exams, it’s okay to show a small comparison table and explain the conclusion (unless numerical data is provided).

Merits and demerits of debt financing (quick list)

Merits:

• may increase EPS via financial leverage (concept)
• interest is a fixed cost; planning becomes easier (concept)
• possible tax benefit on interest (concept)

Demerits:

• fixed interest increases financial risk
• may reduce flexibility; risk of default during low EBIT periods
• high debt may harm creditworthiness (concept)

Key points for exam writing

For 3 marks:

• give definition + one small table (types of leverage or systematic points).

For 5 marks:

• headings: Meaning → Types → EBIT–EPS idea → conclusion,
• use bold keywords and a table/flow.

Quick recap (1-minute revision)

• Capital structure = long-term mix of debt + equity.
• Leverage uses fixed costs to magnify results.
• Operating leverage: sales → EBIT; financial leverage: EBIT → EPS.
• Debt can raise EPS in good times but increases risk in bad times.
• EBIT–EPS analysis compares financing plans at different EBIT levels.