What is financial leverage? Why should we use financial leverage?

In the financial sector, a commonly used term is “leverage”. So what is leverage and why businesses today use financial leverage to generate returns on operating assets.

leverage

Financial leverage is understood simply as using borrowed capital to invest instead of using entirely your own capital to bring your own profits, wise use of financial leverage will help bring a lot of profits. big.

However, using financial leverage is not sure to be successful, it is like a double-edged sword, if customers apply well, they will profit, and if they do not apply well, there will be serious consequences.

What is financial leverage?

Financial leverage, abbreviated to FL.

Financial leverage is the degree of use of borrowed capital in a firm’s total capital in the hope of an increase in return on equity (ROE) or earnings per ordinary share (EPS).

Financial leverage is the combination of liabilities and equity in the management of a business’s financial policy. Financial leverage will be huge in businesses with a higher ratio of liabilities than equity. Conversely, the financial leverage will be low when the proportion of liabilities is less than the proportion of equity.

Financial leverage index groups

Total Liabilities / Total Assets (D / A)

The debt-to-total assets (D / A) ratio measures how well the firm uses debt to finance its total assets. This means about what percentage of the current total assets of the financed business is debt.

This coefficient depends on many factors: the purpose of the loan, the field of business activity, the size of the business, the type of business. To know whether this ratio is high or low can be compared with the industry average.

Debt / Equity ratio (D / C)

Total debt / (Total debt + Equity)

This ratio of debt to capital (D / C) provides researchers and investors with the financial strength and financial structure of the business. An enterprise with a high debt-to-capital ratio compared to the industry average, that business may have a negative financial situation.

Total debt / Equity (D / E)

The debt-to-equity ratio (D / E) reflects the firm’s financial size, giving us an idea of ​​the debt and equity ratio it uses to pay for its operations. The debt to equity ratio is one of the most common leverage ratios.

Financial leverage ratio

Average total assets / Average equity

This coefficient shows the average loan and equity over a period. This low ratio shows financial autonomy but also shows that businesses have not taken advantage of many advantages of financial leverage.

Interest payment ratio (EBIT / Interest expense)

Interest payment coefficient indicates the level of profit before tax and loan interest ensure the ability to pay interest of a business.

This index> 1 proves that the enterprise is fully capable of paying interest.
This indicator

Why should businesses use leverage?

Businesses today prefer to use financial leverage for a number of reasons:

– In order to maintain business operations, businesses will often use debt, with the aim of compensating for capital shortages and the desire to increase return on equity (ROE) or income per income. Stock (EPS).

Why should businesses use financial leverage

And the reality shows that many investors use financial leverage to successfully trade real estate and earn a huge profit.

Example: Mr. T buys a house in the new construction stage at a preferential price, is reduced by 20%, about 1.4 million PHP and paid 20% in advance (280.000 PHP). With the current preferential loan policy at the bank, Mr. T has borrowed the installment payment according to the construction schedule. While waiting for the house to be completed, Mr. T sells the apartment for 2 million (finishing house price). After the time of reselling the house, Mr. T brings back PHP 600.000 to him, minus a bank loan of PHP 400.000 and other costs, Mr. T pocketed about 200.000 PHP for himself.

– Financial leverage as a tool to promote after-tax returns from the equity of the owner, as well as a tool to inhibit that increase. Success or failure is due to the wisdom of investors when choosing a financial structure, the ability to increase profits is the wishes of the owners, in which financial leverage is a tool. is preferred by managers.

– Enterprises also use financial leverage as “Tax shield”. Because the interest payable is considered a reasonable expense and is deducted from the taxable income of the business. Helping businesses pay less tax, increase profits.

Formula for calculating financial leverage

The magnitude of the financial leverage at a level of profit before tax and interest is calculated by the following formula:

Here, EBIT is the profit before tax and interest, EPS is the profit of equity. If the symbol I is the interest payable after a number of changes, we have the following formula:

financial-leverage-formula-2

Formula for calculating financial leverage

Inside:

  • F: Fixed cost of business (not including interest)
  • v: Variable cost of 1 product unit
  • p: Selling price of the product unit
  • Q: Number of products sold

Thus, if the business owner has a capital structure with a larger portion of the loan, the return to equity will increase more when the profit before tax and interest increase, otherwise there will be a profit of equity. Equity decreases more when profit before tax and interest rate decrease.

Firms with a larger capital structure have a higher chance of reaping the return on equity, but associated with it is also a greater financial risk.

See also: What is Swift Code? List of Swift Code codes of banks in Philippines

Some notes when using financial leverage

Using financial leverage brings a source of profit for the business but still has great potential risks. Therefore, enterprises must pay attention to the following issues:

When the investor lacks direction, it is easy to lead to a crisis or if the investor makes a mistake in making the purchase and sale difficult, leading to the situation of capital stagnation, even if not able to manage it in time, it can lead to a situation. empty-handed.

The selection of capital sources must also be very cautious because if you borrow money with high interest rates, profits will decrease, and if you are in danger, the high interest rate will make investors suffer. Please choose banks with preferential loan programs such as Metrobank, PSI, BDO,….

Currently, investors use financial leverage as a “stimulant” with the expectation that the return on assets is higher than the interest rate, which can bring very high profits. risk again. Therefore, investors should consider carefully before using financial leverage to invest profitably.

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