Financial Leverage Explained with Example

Definition

Financial leverage is the ratio of a company’s debt to equity. It characterizes the degree of risk and stability of the company. The less financial leverage, the more stable the position. On the other hand, borrowed capital allows you to increase the return on equity ratio, i.e. get additional profit on equity capital. In other words, financial leverage means an increase or decrease in the return on equity due to the presence of debt in the capital structure.

Financial Leverage Explained with Example

Purpose

The purpose of using financial leverage is to increase the company’s profits by changing the capital structure: shares of equity and borrowed funds. It should be noted that an increase in the share of borrowed capital (short-term and long-term liabilities) of an enterprise leads to a decrease in its financial independence. But at the same time, with an increase in the financial risk of an enterprise, the possibility of obtaining greater profits also increases.

The effect of financial leverage is explained by the fact that the attraction of additional funds makes it possible to increase the efficiency of the production and economic activities of the company. After all, the attracted capital can be used to create new assets that will increase both the cash flow and the net profit of the business. Additional cash flow leads to an increase in the value of the company for investors and shareholders, which is one of the strategic objectives for the owners of the company.

For example, you want to invest in a project that requires $80,000 and gives a 7% return on investment. You can invest your own money and in this case, you will get a profit of $5,600 or 7% of your own money invested.

You also have to option to invest only $50,000 of your own money and borrow the rest with 6% interest. This time you will have to pay $1,800 in interest, which will leave you $3,800 in profits. At first, it might seem that it is wiser it invest only your own money and not borrow any funds. However, if you look at the return on your own money in percentage format, you will see that this way you actually got more for every dollar you invested.

How much more? You will get 7.6% of the money you invested. This percentage can be increased if you borrow more, but keep in mind that the risks also increase. Investors need to weigh all the pros and cons of using the financial leverage and use it to their advantage while also effectively managing their risks.

Optimal Financial Leverage

So, what are the optimal financial leverage and capital structure? How much outside resources can be attracted for development? Unfortunately, there is no definite answer and cannot be, since much depends on the specifics of a particular business.

A business whose revenues are stable and predictable can afford lower coverage ratios. The ability to quickly get additional cash in the form of new loans will also instill more confidence. A lot also depends on the risk policy of the owners and managers of the enterprise. The policy is based on the chosen strategy and on whether the company is aimed at maximizing short-term profit or if stability has a higher priority.

The leverage and interest coverage ratio show the level of risk of a possible decrease in the return on equity and incurring losses. In a real situation, the appropriateness of attracting borrowed funds is determined by the additional economic benefits obtained from their use. The increase in the operating profit of a company by attracting borrowed funds should be greater than the total amount of interest paid over the period of borrowing.

Financial Leverage Explained with Example

This is also true when evaluating investment projects, when the profit for a long-term project must not only exceed the interest on the loan, ensure the loan repayment, but also ensure the balance of profit sufficient (taking into account the time value of money) for the profitability of the initial investment. This is also true in the case of short-term borrowing when the company expects to receive additional profit with the help of borrowed funds, sufficient to pay interest, and realistically assesses its ability to return them.

Nonetheless, it is considered that the optimal leverage to be in the range from 0.5 to 0.7. This suggests that the share of borrowed funds in the overall structure of the enterprise ranges from 50% to 70%. With an increase in the share of borrowed capital, financial risks increase, which includes the possibility of a loss of financial independence, solvency, and the risk of bankruptcy. If the borrowed capital is less than 50%, the company misses the opportunity to increase profits. The optimal size of the effect of financial leverage is considered to be a value equal to 30-50% of the return on assets (ROA).

Financial Leverage Explained with Example

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