Financial leverage (or financial leverage) reflects the ratio of debt to equity of a company. The lower its value, the more stable the company's position is considered, and its activities are less risky.
The concept of financial leverage and its economic meaning
Any commercial activity involves certain risks. If they are determined by the structure of capital sources, then they belong to the group of financial risks. Their most important characteristic is the ratio of own funds to borrowed funds. After all, the attraction of external financing is associated with the payment of interest for its use. Therefore, in case of negative economic indicators (for example, with a decrease in sales, personnel problems, etc.), the company may have an unbearable debt burden. At the same time, the price for the additionally attracted capital will increase.
Financial leverage arises when the company uses borrowed funds. A situation is considered normal in which the payment for the borrowed capital is less than the profit that it brings. When this additional profit is summed up with the income received from equity capital, an increase in profitability is noted.
In the commodity and stock market, the financial leverage is the margin requirements, i.e. the ratio of the amount of the deposit to the total value of the transaction. This ratio is called leverage.
The leverage ratio is directly proportional to the financial risk of the enterprise and reflects the share of borrowed funds in financing. It is calculated as the ratio of the sum of long-term and short-term liabilities to the company's own funds.
Its calculation is necessary to control the structure of sources of funds. The normal value for this indicator is between 0.5 and 0.8. A high value of the ratio can be afforded by companies that have stable and well-predictable dynamics of financial indicators, as well as companies with a high share of liquid assets - trade, sales, banking.
The efficiency of borrowed capital largely depends on the return on assets and the lending interest rate. If the profitability is lower than the rate, then it is unprofitable to use the borrowed capital.
Calculation of the effect of financial leverage
To determine the correlation between financial leverage and return on equity, an indicator called the effect of financial leverage is used. Its essence lies in the fact that it reflects how much interest the equity capital grows when using borrowings.
There is a leverage effect due to the difference between the return on assets and the cost of borrowed funds. To calculate it, a multivariate model is used.
The calculation formula is DFL = (ROAEBIT-WACLC) * (1-TRP / 100) * LC / EC. In this formula, ROAEBIT is the return on assets calculated through earnings before interest and taxes (EBIT),%; WACLC - weighted average cost of borrowed capital,%; EC is the average annual amount of equity capital; LC is the average annual amount of borrowed capital; RP - income tax rate,%. The recommended value for this indicator is in the range from 0.33 to 0.5.
