What does the financial leverage effect show? Financial leverage and methods for determining it.
To calculate the effect financial leverage(EFR) it is necessary to calculate the economic profitability (ER) and the average calculated interest rate (ARSP).
EFR = 2/3 (ER - SRSP) * ZS / SS
Where ER = Net result of operation of the investment / (Equity + Borrowed funds),
SISP = Financial interest costs / Borrowings * 100%
This formula can be presented in a more expanded version.
Purpose of the service. Using an online calculator, a step-by-step analysis of the enterprise’s activities is carried out:
- Calculation of the effect of financial leverage.
- Analysis of profit sensitivity to changes in the analyzed factor.
- Determination of the compensating change in sales volume when the analyzed factor changes.
Instructions. Fill out the table, click Next. The report with the solution will be saved in MS Word format.
Indicators such as Own funds (Equity), Borrowed funds (BF), Retained earnings from previous years, Authorized capital, Current assets, Current liabilities and Return on sales can be determined from the data balance sheet(find using a calculator).
Classification of the effect of financial leverage
Example. Table 1 - Initial data
| Indicators | Meaning |
| 1. Revenue from sales thousand rubles. | 12231.8 |
| 2. Variable costs thousand rubles. | 10970.5 |
| 3. Fixed costs thousand rubles. | 687.6 |
| 4. Own funds (SS) thousand rubles. | 1130.4 |
| 5. Borrowed funds (BF) thousand rubles. | 180 |
| 6. Financial costs for borrowed funds (FI) thousand rubles. | 32.4 |
Let's define financial indicators activity of the enterprise
Table 1 - Enterprise performance indicators
1. Calculation of the effect of financial leverage
To calculate the effect of financial leverage (EFR), it is necessary to calculate economic profitability (ER) and the average calculated interest rate (ASIR).
ER = NREI / Assets * 100 = 606.1 / (1130.4 + 180) * 100 = 46.25%
SRSP = FI / ZC * 100 = 32.4 / 180 * 100 = 18%
EFR = 2 / 3(ER - SRSP) * ZS / SS = 2 / 3(46.25% - 18%) * 180 / 1130.4 = 3.0%
RCC = 2/3 * ER + EGF = 2/3 * 46.25 + 3.0 = 33.84%
The essence of the financial leverage effect: the effect of financial leverage shows the increase in return on equity obtained as a result of the use of borrowed capital. In our case it was 3.0%.
The effect of financial leverage can also be used to assess the creditworthiness of an enterprise.
Since the financial leverage is less than 1 (0.159), this enterprise can be regarded as creditworthy. The meaning of the financial leverage effect: a company may qualify for an additional loan.
Using the graphical method, we will determine the safe amount of borrowed funds. Typical differential curves are shown in Fig. 1.
Rice. 1. Differential curves
Let's determine the position of our enterprise on the chart.
ER / SRSP = 46.25 / 18 = 2.57
Where does ER = 2.57SRSP come from?
With additional borrowing, it is necessary that the enterprise does not fall below the main curve (the enterprise is between ER = 3SRSP and ER = 2SRSP). Therefore, at the level of taxation neutralization at the point EFR/RSS = 1/3, the permissible leverage of the financial leverage of the AP/SS is 1.0.
Thus, the loan can be increased by 950.4 thousand rubles. and reach 1130.4 thousand rubles.
Let us determine the upper limit of the price of borrowed capital.
ER = 2SRSP
Where does SRSP = 46.25% / 2 = 23.13% come from?
CPSP = FI / ZS
Where does FI = SRSP * ZS = 23.13% * 1130.4 = 261.422 thousand rubles.
Thus, this enterprise, without losing financial stability, can take out an additional amount of borrowed funds of 950.4 thousand rubles. Additional borrowing will cost the company 219.795 thousand rubles if the average interest rate on the loan does not exceed 23.13%.
Let us calculate the critical value of the net result of investment exploitation, i.e. a value at which the effect of financial leverage is zero, and therefore the return on equity is the same for options both with the use of borrowed funds and with the use of only equity.
NREI critical = 1310.4 * 18 = 235.872 thousand rubles.
In our case, the threshold value has been passed, which means that it is profitable for the company to attract borrowed funds.
Reasons for attracting debt capital: the company has good (in the opinion of its owners and top managers) opportunities to implement a certain project, but does not have sufficient own sources of financing. Profit, as the most accessible source of own funds, is limited, borrowed capital on the market banking services not limited. Very often, profits are dispersed across different assets and therefore profits cannot be used directly for financing transactions.
During mobilization debt capital real money arises at a time and in large amounts.
Raising debt capital to enhance the economic potential of an enterprise requires proper justification.
EGF = (ROA - Tsk) x (1 - Kn) x ZK/SK, where ROA is the economic profitability of total capital before taxes (the ratio of the amount of book profit to the average annual amount of total capital), %;
Tsk - weighted average price of borrowed resources (ratio of costs for servicing debt obligations to the average annual amount of borrowed funds), %;
Кн - taxation coefficient (the ratio of the amount of taxes from profit to the amount of balance sheet profit) in the form of a decimal fraction;
ZK - average annual amount of borrowed capital;
SK is the average annual amount of equity capital.
The effect of financial leverage shows by what percentage the amount of equity capital increases due to the attraction of borrowed funds into the turnover of the enterprise. Positive effect of financial leverage occurs in cases where the return on total capital is higher than the weighted average price of borrowed resources, i.e. if ROA > Tsk. For example, the after-tax return on total equity is 15%, while the cost of debt is 10%. The difference between the cost of borrowed funds and the return on total capital will increase the return on equity. Under such conditions, it is beneficial to increase financial leverage, i.e. share of borrowed capital. If ROA is negative, the effect of financial leverage (the “stick” effect), resulting in a depreciation of equity capital, which may cause bankruptcy of the enterprise.
In conditions of inflation, if debts and interest on them are not indexed, the EFR and return on equity(ROE) increase because debt service and the debt itself are paid for with already depreciated money.
Then the effect of financial leverage will be equal to: EGF = x (1 - Kn) x ZK/SK + (I x ZK)/SK x 100%, where I is the inflation rate as a decimal fraction.
Attracting borrowed funds changes the structure of sources, increases the financial dependence of the company, increases the financial risk associated with it, and leads to an increase in WACC. This explains the importance of such a characteristic as financial leverage.
Essence, significance and effect financial leverage :
- a high share of borrowed capital in the total amount of financing sources is characterized as a high level of financial leverage and indicates a high level of financial risk;
- financial leverage indicates the presence and degree of financial dependence of the company on landers;
- attracting long-term loans and borrowings is accompanied by an increase in financial leverage and, accordingly, financial risk;
- the essence of financial risk is that regular payments (for example, interest) are mandatory, therefore, if the source is insufficient, and this is earnings before interest and taxes, it may be necessary to liquidate part of the assets;
- for a company with high level financial leverage, even a small change in earnings before interest and taxes due to known restrictions on its use (first of all, the requirements of landers, i.e. third-party suppliers of financial resources, are satisfied, and only then - the owners of the enterprise) can lead to a significant change in net profit.
Measures of financial leverage:
- debt/equity ratio;
- the ratio of the rate of change in net profit to the rate of change in gross profit.
Any company strives to increase its market share. In the process of formation and development, the company creates and increases its own capital. At the same time, very often in order to spur growth or launch new directions, it is necessary to attract external capital. For a modern economy with a well-developed banking sector and exchange structures, gaining access to borrowed capital is not difficult.
Capital Balance Theory
When attracting borrowed funds, it is important to maintain a balance between the repayment obligations undertaken and the goals set. By violating it, you can get a significant decrease in the pace of development and a deterioration in all indicators.
According to the Modigliani-Miller theory, the presence of a certain percentage of debt capital in the structure of the total capital that a company has is beneficial for the current and future development of the company. Borrowed funds at an acceptable service price allow you to direct them to promising areas, in this case the money multiplier effect will work when one invested unit gives an increase in an additional unit.
But if there is a high share of borrowed funds, the company may fail to fulfill its both internal and external obligations due to an increase in the amount of loan servicing.
Thus, the main task of a company attracting third-party capital is to calculate the optimal financial leverage ratio and create equilibrium in general structure capital. This is very important.
Financial leverage (leverage), definition
Leverage represents the existing ratio between two capitals in the company: own and attracted. For better understanding, the definition can be formulated differently. The financial leverage ratio is an indicator of the risk that a company assumes by creating a certain structure of financing sources, that is, using both its own and borrowed funds.
For understanding: the word “leverage” is an English word that means “leverage” in translation, therefore the leverage of financial leverage is often called “financial leverage”. It is important to understand this and not think that these words are different.
Shoulder Components
The financial leverage ratio takes into account several components that will influence its indicator and effects. Among them are:
- Taxes, namely the tax burden that a company bears when carrying out its activities. Tax rates are set by the state, so the company this issue can regulate the level of tax deductions only by changing the selected tax regimes.
- Financial leverage indicator. This is the debt to equity ratio. This indicator alone can give an initial idea of the price of attracted capital.
- Financial leverage differential. Also a compliance indicator, which is based on the difference in the profitability of assets and the interest paid for loans taken.
Financial leverage formula
You can calculate the financial leverage ratio, the formula of which is quite simple, as follows.
Leverage = Amount of debt capital / Amount of equity capital
At first glance, everything is clear and simple. The formula shows that the leverage ratio is the ratio of all borrowed funds to equity capital.
Leverage, effects
Leverage (financial) is associated with borrowed funds, which are aimed at developing the company, and profitability. Having determined the capital structure and obtained the ratio, that is, by calculating the financial leverage ratio, the formula for which is presented on the balance sheet, you can assess the efficiency of capital (that is, its profitability).
The leverage effect gives an understanding of how much the efficiency of equity capital will change due to the fact that external capital has been attracted into the company’s turnover. To calculate the effect, there is an additional formula that takes into account the indicator calculated above.
There are positive and negative effects of financial leverage.
The first is when the difference between the return on total capital after all taxes have been paid exceeds interest rate for the loan provided. If the effect is greater than zero, that is, positive, then increasing leverage is profitable and you can attract additional borrowed capital.
If the effect has a negative sign, then measures should be taken to prevent losses.
American and European interpretations of the leverage effect
Two interpretations of the leverage effect are based on what accents in to a greater extent taken into account in the calculation. This is a more in-depth look at how the financial leverage ratio shows the magnitude of the impact on a company's financial results.
The American model or concept considers financial leverage through net profit and profit received after the company has made all tax payments. This model takes into account the tax component.
The European concept is based on the efficiency of using borrowed capital. It examines the effects of using equity capital and compares them with the effect of using debt capital. In other words, the concept is based on assessing the profitability of each type of capital.
Conclusion
Any company strives, at a minimum, to achieve a break-even point, and, at a maximum, to obtain high profitability indicators. There is not always enough equity capital to achieve all the goals set. Many companies resort to borrowing funds for development. It is important to maintain a balance between your own capital and attracted capital. It is to determine how well this balance is maintained at the current time that the financial leverage indicator is used. It helps determine how much the current capital structure allows for additional debt.
When comparing 2 enterprises with the same level of economic profitability (Profit from sales/all Assets), the difference in m/d between them may be the absence of loans in 1 of them, while the other actively attracts borrowed funds (PE/SC). That. the difference lies in the different level of return on equity obtained through a different structure financial sources. The difference in m/d between two levels of profitability is the level of the effect of financial leverage. EGF there is an increase in the net return on equity obtained as a result of using a loan, despite its payment.
EFR=(1-T)*(ER - St%)*ZK/SC, where T is the income tax rate (in shares), ER-eq. profitability (%), St% - average interest rate on the loan,
ER = Sales Profit/Total Assets. ER characterizes the investment attractiveness of an enterprise. There is no efficiency in using all capital, despite the fact that you still have to pay interest on the loan.
The first component of the EGF is called differential and characterizes the difference between the economic profitability of assets and the average calculated interest rate on borrowed funds (ER - SRSP).
The second component - financial leverage (financial activity ratio) - reflects the ratio between borrowed and own funds(ZK/SK). The larger it is, the greater the financial risks.
The effect of financial leverage allows you to:
Justify financial risks and assess financial risks.
Rules arising from the EGF formula:
If new borrowing brings an increase in the level of EGF, then it is beneficial for the organization. It is recommended to carefully monitor the state of the differential: when increasing financial leverage, the bank tends to compensate for the increase in its own risk by increasing the loan price
The larger the differential (d), the less risk(accordingly, the smaller d, the greater the risk). In this case, the lender's risk is expressed by the value of the differential. If d>0, you can borrow if d<0, то высокие риск - не рекомендуется занимать, эффект от использования ЗК меньше суммы % за кредит; если d=0, то весь эффект от использования ЗК пойдет на уплату % за кредит.
EGF represents an important concept that, under certain conditions, allows one to assess the impact of debt on the profitability of an organization. Financial leverage is typical for situations where the structure of sources of capital formation contains obligations with a fixed interest rate. In this case, an effect similar to the use of operating leverage is formed, that is, profit after interest increases/declines at a faster rate than changes in the volume of output.
The advantage of fin. lever: capital borrowed by an organization at a fixed interest rate can be used in the process of activity in such a way that it will generate a higher profit than the interest paid. The difference accumulates as the organization's profit.
The effect of operating leverage affects the result before financial expenses and taxes are taken into account. EFR occurs when an organization is in debt or has a source of financing that entails the payment of constant amounts. It affects net income and thus return on equity. EGF increases the impact of annual turnover on return on equity.
Total leverage effect = Operating leverage effect*Financial leverage effect.
With a high value of both levers, any small increase in the annual turnover of an organization will significantly affect the value of the return on its equity capital.
The effect of operating leverage is the presence of a relationship between changes in sales revenue and changes in profit. The strength of operating leverage is calculated as the quotient of sales revenue after reimbursement of variable costs by profit. The action of operating leverage generates entrepreneurial risk.
Financial leverage characterizes the ratio of all assets to equity, and the effect of financial leverage is calculated accordingly by multiplying it by the economic profitability indicator, that is, it characterizes the return on equity (the ratio of profit to equity).
The effect of financial leverage is an increase in the profitability of equity capital obtained through the use of a loan, despite the payment of the latter.
An enterprise using only its own funds limits its profitability to approximately two-thirds of economic profitability.
РСС – net return on equity;
ER – economic profitability.
An enterprise using a loan increases or decreases the profitability of its own funds, depending on the ratio of its own and borrowed funds in liabilities and on the interest rate. Then the financial leverage effect (FLE) arises:
(3)
Let's consider the mechanism of financial leverage. The mechanism includes differential and leverage.
Differential is the difference between the economic return on assets and the average calculated interest rate (ASRP) on borrowed funds.
Due to taxation, unfortunately, only two thirds remain of the differential (1/3 is the profit tax rate).
Leverage of financial leverage – characterizes the strength of the influence of financial leverage.
(4)
Let's combine both components of the financial leverage effect and get:
(5)
(6)
Thus, the first way to calculate the level of financial leverage effect is:
(7)
The loan should lead to an increase in financial leverage. In the absence of such an increase, it is better not to take out a loan at all, or at least calculate the maximum maximum amount of loan that leads to growth.
If the loan rate is higher than the level of economic profitability of the tourism enterprise, then increasing the volume of production due to this loan will not lead to the repayment of the loan, but to the transformation of the enterprise’s activities from profitable to unprofitable.
There are two important rules to highlight here:
1. If new borrowing brings the enterprise an increase in the level of financial leverage, then such borrowing is profitable. But at the same time, it is necessary to monitor the state of the differential: when increasing the leverage of financial leverage, the banker is inclined to compensate for the increase in his risk by increasing the price of his “product” - a loan.
2. The lender’s risk is expressed by the value of the differential: the larger the differential, the lower the risk; the smaller the differential, the greater the risk.
You should not increase your financial leverage at any cost; you need to adjust it depending on the differential. The differential must not be negative. And the effect of financial leverage in world practice should be equal to 0.3 - 0.5 of the level of economic return on assets.
Financial leverage allows you to assess the impact of an enterprise's capital structure on profit. The calculation of this indicator is appropriate from the point of view of assessing the effectiveness of past and planning future financial activities of the enterprise.
The advantage of rational use of financial leverage lies in the possibility of generating income from the use of capital borrowed at a fixed interest rate in investment activities that generate a higher interest rate than the one paid. In practice, the value of financial leverage is influenced by the field of activity of the enterprise, legal and credit restrictions, and so on. Too high a value of financial leverage is dangerous for shareholders, as it is associated with a significant amount of risk.
Commercial risk means uncertainty in a possible result, the uncertainty of this result of activity. Let us remind you that risks are divided into two types: pure and speculative.
Financial risks are speculative risks. An investor, making a venture capital investment, knows in advance that only two types of results are possible for him: income or loss. A feature of financial risk is the likelihood of damage as a result of any operations in the financial, credit and exchange spheres, transactions with stock securities, that is, the risk that arises from the nature of these operations. Financial risks include credit risk, interest rate risk, currency risk, and the risk of lost financial profits.
The concept of financial risk is closely related to the category of financial leverage. Financial risk is the risk associated with a possible lack of funds to pay interest on long-term loans. An increase in financial leverage is accompanied by an increase in the degree of riskiness of a given enterprise. This is manifested in the fact that for two tourism enterprises with the same production volume, but different levels of financial leverage, the variation in net profit due to changes in production volume will not be the same - it will be greater for the enterprise with a higher level of financial leverage.
The effect of financial leverage can also be interpreted as the change in net profit per each ordinary share (as a percentage) generated by a given change in the net result of operating an investment (also as a percentage). This perception of the effect of financial leverage is typical mainly for the American school of financial management.
Using this formula, they answer the question by how many percent the net profit for each ordinary share will change if the net result of operating the investment (profitability) changes by one percent.
After a number of transformations, you can go to the following formula:
Hence the conclusion: the higher the interest and the lower the profit, the greater the power of financial leverage and the higher the financial risk.
When forming a rational structure of sources of funds, one must proceed from the following fact: find a ratio between borrowed and equity funds at which the value of the enterprise's shares will be the highest. This, in turn, becomes possible with a sufficiently high, but not excessive, effect of financial leverage. The level of debt is a market indicator for the investor of the well-being of the enterprise. An extremely high proportion of borrowed funds in liabilities indicates an increased risk of bankruptcy. If a tourist enterprise prefers to make do with its own funds, then the risk of bankruptcy is limited, but investors, receiving relatively modest dividends, believe that the enterprise does not pursue the goal of maximizing profits, and begin to dump shares, reducing the market value of the enterprise.
There are two important rules:
1. If the net result of operating investments per share is small (and the differential of financial leverage is usually negative, the net return on equity and the level of dividends are reduced), then it is more profitable to increase own funds by issuing shares than to take out a loan: attracting borrowed funds funds are more expensive for the enterprise than raising its own funds. However, there may be difficulties in the initial public offering process.
2. If the net result of operating investments per share is large (and the differential of financial leverage is most often positive, the net return on equity and the level of dividends are increased), then it is more profitable to take out a loan than to increase equity: raising borrowed funds costs the enterprise cheaper than raising your own funds. Very important: it is necessary to control the power of influence of financial and operating leverage in case of their possible simultaneous increase.
Therefore, you should start by calculating net return on equity and net earnings per share.
(10)
1. The rate of increase in the enterprise’s turnover. Increased turnover growth rates also require increased financing. This is due to an increase in variable, and often fixed costs, an almost inevitable swelling of accounts receivable, as well as many other different reasons, including cost inflation. Therefore, during a steep rise in turnover, firms tend to rely not on internal, but on external financing, with an emphasis on increasing the share of borrowed funds in it, since issue costs, costs of initial public offerings and subsequent dividend payments most often exceed the cost of debt instruments;
2. Stability of turnover dynamics. An enterprise with a stable turnover can afford a relatively larger share of borrowed funds in liabilities and more significant fixed costs;
3. Level and dynamics of profitability. It has been noted that the most profitable enterprises have a relatively low share of debt financing on average over a long period. The enterprise generates sufficient profit to finance development and pay dividends and operates increasingly with its own funds;
4. Asset structure. If an enterprise has significant general purpose assets, which by their very nature can serve as collateral for loans, then an increase in the share of borrowed funds in the liability structure is quite logical;
5. The severity of taxation. The higher the income tax, the fewer tax benefits and opportunities to use accelerated depreciation, the more attractive debt financing is for the enterprise due to the attribution of at least part of the interest on the loan to the cost price;
6. Attitude of creditors to the enterprise. The play of supply and demand in the money and financial markets determines the average conditions for credit financing. But the specific conditions for providing this loan may deviate from the average depending on the financial and economic situation of the enterprise. Do bankers compete for the right to provide a loan to an enterprise, or do they have to beg money from lenders - that is the question. The real capabilities of the enterprise to form the desired structure of funds largely depend on the answer to it;
8. Acceptable degree of risk for enterprise managers. People at the helm can be more or less conservative in terms of determining acceptable risk when making financial decisions;
9. Strategic target financial guidelines of the enterprise in the context of its actually achieved financial and economic position;
10. State of the short- and long-term capital market. In unfavorable conditions on the money and capital markets, one often has to simply submit to circumstances, postponing until better times the formation of a rational structure of sources of funds;
11. Financial flexibility of the enterprise.
Example.
Determining the amount of financial leverage of an enterprise’s economic activity using the example of the Rus Hotel. Let us determine the feasibility of the amount of the loan attracted. The structure of the enterprise's funds is presented in Table 1.
Table 1
Structure of financial assets of the Rus Hotel enterprise
| Indicator | Magnitude |
| Initial values | |
| Hotel assets minus credit debt, million rubles. | 100,00 |
| Borrowed funds, million rubles. | 40,00 |
| Own funds, million rubles. | 60,00 |
| Net result of investment exploitation, million rubles. | 9,80 |
| Debt servicing costs, million rubles. | 3,50 |
| Calculated values | |
| Economic profitability of own funds, % | 9,80 |
| Average calculated interest rate, % | 8,75 |
| Financial leverage differential excluding income tax, % | 1,05 |
| Financial leverage differential taking into account income tax, % | 0,7 |
| Leverage | 0,67 |
| Effect of financial leverage, % | 0,47 |
Based on these data, we can draw the following conclusion: the Rus Hotel can take out loans, but the differential is close to zero. Minor changes in the production process or increases in interest rates can reverse the leverage effect. There may come a time when the differential becomes less than zero. Then the effect of financial leverage will act to the detriment of the hotel.
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