Financial leverage is the ratio of the company's borrowed capital to its own budget. Thanks to him, you can study the financial situation of the company, the degree of risk of the collapse of the enterprise or the likelihood of its success. The lower the leverage, the more stable the company's position. But do not forget that with the help of a loan many small enterprises grow to larger ones, and large ones, having received additional profit to their own capital, improve their position.
The goal of financial leverage
Financial leverage in the economy can be called leverage, leverage, financial leverage, but the meaning does not change. The lever in physics helps, with less effort, to lift heavier objects, just like in economics. Financial ratio Leverage allows you to make big profits. It takes less time and energy to fulfill a dream. Sometimes one can come across such a definition: “Financial leverage is an increase in profitability personal income enterprises due to the use of borrowed funds. ”
Change enterprise capital structure (shares of own and borrowed funds) allows you to increase the company's net profit. As a rule, the additional capital received as a result of leverage is used to create new assets, improve company productivity, expand branches, etc.
The more money that rotates inside the enterprise, the more expensive cooperation with owners is for investors and shareholders, and this, of course, is beneficial for general directors.
Based on the concept of leverage, it can be argued that the effect of financial leverage is the ratio of borrowed capital to own profit, expressed as a percentage.
Who needs to know what leverage is and why?
Not only for investors and lenders, it is important to understand and be able to evaluate the structure of the investment market. However, for an investor or banker, the amount of leverage serves as an excellent guide for further cooperation with the company and the size of credit rates.
Entrepreneurs, company owners, financial managers themselves need to know the structure of leverage and be able to evaluate it in order to understand the financial condition of the company and its dependence on external loans. If inexperienced entrepreneurs neglect knowledge of leverage, they can easily lose their financial independence due to large loans and external debts. If the directors decide that the company is developing well without a credit history, then they will miss the opportunity to increase the return on assets, which means they will slow down the process of raising the enterprise on the career ladder.
External loans allow you to quickly and efficiently increase the productivity of the company, but they can also draw it into economic dependence on loans.
It is also worth remembering that an entrepreneur should never take unjustified loans (unnecessary for this stage of company development). During the process of obtaining a loan, it is necessary to accurately represent the amount of funds needed to expand the company or increase sales.
Formula of action of financial leverage.
In the economy, there are many nuances, without knowing which, newcomers easily fall for credit tricks and do not achieve goals, blaming financial leverage for everything. Its formula should be firmly rooted in the brains of both newcomers to business and professionals.
EGF = (1 - Sn) x D x FR
EGF - the effect of financial leverage;
SN - direct tax on profit of the organization, expressed in decimal (may vary depending on the type of activity of the enterprise);
D - differential, the difference between the rate of return (RO) of assets and the percentage of the credit rate;
FR - financial leverage, the ratio of the average borrowed capital of the enterprise to the amount of equity.
Leverage patterns
In accordance with the formula, several patterns of leverage can be derived.
Differential should always be positive. This is an important impetus for leverage, which allows the borrower to understand the degree of risk of borrowing large amounts to the entrepreneur. The higher the score, the lower the risk for the banker.
The shoulder (RF) also contains crucial information for both participants in the process. The larger it is, the higher the risk for both the banker and the entrepreneur.
Based on these two aspects, it is obvious how leverage helps to increase profitability. The financial lever serves to increase not only one's own profit, but also to determine the amount of the loan amount that an entrepreneur can attract.
Average leverage
Practical methods were used to determine the optimal value of the indicator of financial leverage (in percentage terms). For an average enterprise, the ratio of leverage to equity is from 50 to 70%. If this indicator decreases by at least 10%, the entrepreneur’s chance to develop his company and achieve success is lost, and if it increases to 80 or 90%, the financial independence of the entire enterprise is put at enormous risk.
However, do not forget that the normal level of leverage also depends on the industry, scale (business size, number of branches, etc.) and even on the method of organization of management and the approach to building the structure of the company.
The main components of financial leverage
Financial leverage is largely dependent on secondary factors. Each of them needs to be disassembled separately. The indicator of financial leverage is equal to the ratio of credit capital to equity. Therefore, the factor that changes the indicator of the leverage effect in the first place is the return on assets, that is, the ratio of the company's net profit (for the year) to the value of all assets (the company's balance).
The financial leverage ratio is the leverage lever, which shows what share in the overall structure of the company is borrowed or other funds required to pay (loans, courts, etc.). Using leverage, the strength of influence on the net profit of borrowed funds is determined.
Why do I need a tax proofreader?
When using financial leverage in calculations, experienced economists turn to such a definition as a tax corrector. Thanks to him, you can find out how the effect of financial leverage changes with an increase or decrease in income tax. Recall that income tax is paid by all legal entities of the Russian Federation (OJSC, ZAO, etc.), and its rate is different and depends on the type of activity and the size of real income. So, the tax corrector is used only in three cases:
- If there are different tax rates;
- If the company uses privileges (for certain types of activity);
- If the subsidiaries (branches) are located in the free economic zones of the state where there is a preferential treatment or the branches are located in foreign countries with the same zones.
Thus, when the tax burden is reduced for one of these reasons, the dependence of the effect of financial leverage on the corrector decreases markedly.
Operating leverage
Operating and financial leverage in the stock market keep up. The indicator of the first indicates changes in the rate of growth of profit from sales. If you know what operating lever you can accurately predict the change in profit for the year when changing the indicator of monthly revenue.
There is a concept in the market breakeven points showing the amount of income needed to cover expenses. At this point, if you display it on the coordinate line, the net profit is zero, the left side is negative (the company incurs losses), the right is positive (the company covers expenses and the net profit remains). This line is called a measure of the financial strength of the company.
The effect of operating leverage
The strength with which the operating leverage operates at the enterprise depends on the average weight of fixed costs in the total cost of costs (fixed and variable). So, the effect of production leverage is the most important indicator of the budgetary risk of an enterprise, calculated by the following formula:
- ESM = (Fibreboard + PR) / Fibreboard
- ESM - the effect of the operating lever;
- Fiberboard - income before interest (taxes and debts);
- PR - fixed production costs (the indicator does not depend on revenue).
Why is the effectiveness of financial leverage reduced?
The financial leverage of the enterprise, of course, shows how competently the owner handles his own and borrowed funds, but the risk always exists, especially when there are problems with the economic situation in the market. So under what factors does the effectiveness of financial leverage decrease and why does this happen?
During the deterioration of the financial situation in the market, the cost of attracting a loan rises sharply, which, of course, will affect the indicator of financial leverage depending on the choice of an entrepreneur: take a loan at new rates or use your own income.
A decrease in the financial stability of the company due to the economic crisis or inept money handling (permanent loans, big expenses) leads to an increase in the risk of bankruptcy of the company. Interest rates for such people are rising, which means that the indicator of financial leverage is reduced. Sometimes it can go to zero or take a negative value.
A decrease in demand for goods leads to a decrease in income. Thus, the return on assets decreases, and this factor is the most important in the formation of financial leverage.
It follows that the effectiveness of financial leverage falls due to external factors (market conditions), and not through the fault of the entrepreneur or accountants.
Entrepreneurship - risk or delicate work?
Thus, financial leverage determines the most important indicator of the state of the enterprise in the economy, is calculated as the ratio of borrowed capital to equity, and has a so-called average value of 50 to 70% depending on the type of activity. However, many young entrepreneurs, due to their inexperience, do not attach due importance to leverage and do not notice how they become financially dependent on larger corporations or bankers.
That is why people who connect their lives with the economy and the stock market need to know all the subtleties, nuances and aspects of entrepreneurship.
