The effect of financial leverage this is an indicator that reflects the change in the return on equity obtained through the use of borrowed funds and is calculated using the following formula:
Where,
DFL - effect of financial leverage, in percent;
t - income tax rate, in relative terms;
ROA - return on assets (economic return on EBIT) in%;
D - borrowed capital;
E - equity.
The effect of financial leverage is manifested in the difference between the cost of borrowed and allocated capital, which allows you to increase profitability equity and reduce financial risks.
The positive effect of financial leverage is based on the fact that the bank rate in the normal economic environment is lower than the return on investment. The negative effect (or the reverse side of financial leverage) occurs when the return on assets falls below the loan rate, which leads to accelerated loss formation.
Incidentally, the common theory is that the US mortgage crisis was a manifestation of the negative effect of financial leverage. When the program of non-standard mortgage lending was launched, interest rates on loans were low, while real estate prices were growing. The low-income strata of the population were involved in financial speculation, since almost the only way for them to repay the loan was the sale of housing that had risen in price. When housing prices crept down, and loan rates rose due to increasing risks (the leverage began to generate losses, not profits), the pyramid collapsed.
Components effect of financial leverage are shown in the figure below:
As can be seen from the figure, the effect of financial leverage (DFL) is the product of two components, adjusted by the tax coefficient (1 - t), which shows the extent to which the effect of financial leverage is manifested due to different levels of income tax.
One of the main components of the formula is the so-called financial leverage differential (Dif) or the difference between the return on the company's assets (economic profitability), calculated on EBIT, and the interest rate on borrowed capital:
Dif = ROA - r
Where,
r - interest rate on borrowed capital, in %;
ROA - return on assets (economic return on EBIT) in%.
The financial leverage differential is the main condition that forms the growth of return on equity. For this, it is necessary that the economic profitability exceed the interest rate of payments for the use of borrowed sources of financing, i.e. the financial leverage differential must be positive. If the differential becomes less than zero, then the effect of financial leverage will only act to the detriment of the organization.
The second component of the effect of financial leverage is the coefficient of financial leverage (shoulder of financial leverage - FLS), which characterizes the strength of the impact of financial leverage and is defined as the ratio of borrowed capital (D) to equity (E):
Thus, the effect of financial leverage consists of the influence of two components: differential and lever arm.
The differential and lever arm are closely interconnected. As long as the return on investment in assets exceeds the price of borrowed funds, i.e. the differential is positive, the return on equity will grow the faster, the higher the ratio of borrowed and own funds. However, as the share of borrowed funds grows, their price rises, profits begin to decline, as a result, the return on assets also falls and, therefore, there is a threat of obtaining a negative differential.
According to economists, based on the study of the empirical material of successful foreign companies, the optimal effect of financial leverage is within 30-50% of the level of economic return on assets (ROA) with leverage of 0.67-0.54. In this case, an increase in the return on equity is ensured not lower than the increase in the profitability of investments in assets.
The effect of financial leverage contributes to the formation of a rational structure of the sources of funds of the enterprise in order to finance the necessary investments and obtain the desired level of return on equity, in which the financial stability of the enterprise is not violated.
Using the above formula, we will calculate the effect of financial leverage.
| Indicators | Ed. rev. | Value |
|---|---|---|
| Equity | thousand roubles. | 45 879,5 |
| Borrowed capital | thousand roubles. | 35 087,9 |
| Total equity | thousand roubles. | 80 967,4 |
| Operating profit | thousand roubles. | 23 478,1 |
| Interest rate on borrowed capital | % | 12,5 |
| The amount of interest on borrowed capital | thousand roubles. | 4 386,0 |
| Income tax rate | % | 24,0 |
| Taxable income | thousand roubles. | 19 092,1 |
| Income tax amount | thousand roubles. | 4 582,1 |
| Net profit | thousand roubles. | 14 510,0 |
| Return on equity | % | 31,6% |
| Effect of financial leverage (DFL) | % | 9,6% |
The calculation results presented in the table show that by attracting borrowed capital, the organization was able to increase the return on equity by 9.6%.
Financial leverage characterizes the possibility of increasing the return on equity and the risk of loss financial stability. The higher the share of borrowed capital, the higher the sensitivity of net income to changes in balance sheet profit. Thus, with additional borrowing, the return on equity may increase, provided:
if ROA > i, then ROE > ROA and ΔROE = (ROA - i) * D/E
Therefore, it is advisable to attract borrowed funds if the achieved return on assets, ROA exceeds the interest rate for the loan, i. Then an increase in the share of borrowed funds will increase the return on equity. However, at the same time, it is necessary to monitor the differential (ROA - i), since with an increase in the leverage of financial leverage (D / E), lenders tend to compensate for their risk by increasing the rate for the loan. The differential reflects the lender's risk: the larger it is, the lower the risk. The differential should not be negative, and the effect of financial leverage should optimally be equal to 30 - 50% of the return on assets, since the stronger the effect of financial leverage, the higher the financial risk of loan default, falling dividends and share prices.
The level of associated risk characterizes the operational and financial leverage. Operational financial leverage along with the positive effect of increasing return on assets and equity as a result of growth in sales and borrowings, it also reflects the risk of lower profitability and incurring losses.
“The success of long-term lending in any area of business depends on a clear understanding of what cannot be trusted in the accounts,” Robert Jackson, US Supreme Court Justice.
So, let's figure out what the success of lending depends on, and what is the role of reporting in this matter.
Loans are a double-edged sword.
Their inefficient use can lead to an increase in debt, inability to pay off it and, as a result, to bankruptcy.
And vice versa, with the help of borrowed funds, you can also increase the company's own funds, but subject to skilful management, competent and timely control over such an indicator as the leverage of financial leverage.
The formula for its calculation and the role in assessing the effectiveness of the use of borrowed funds are in the article.
Financial Leverage: Calculation Formula
The financial leverage of an enterprise (analogue: leverage, credit leverage, financial leverage, leverage) - shows how the use of borrowed capital of an enterprise affects the amount of net profit. Financial leverage is one of the key concepts of financial and investment analysis enterprises.
In physics, the use of a lever allows, with less effort, to raise more weight. A similar principle of action in the economy for financial leverage, which allows you to increase profits with less effort.
The purpose of using financial leverage is to increase the profit of the enterprise by changing the structure of capital: the shares of own 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 the increase in the financial risk of the enterprise, the possibility of obtaining greater profits also increases.
economic sense
The effect of financial leverage is explained by the fact that attracting additional funds makes it possible to increase the efficiency of the production and economic activities of the enterprise. After all, the attracted capital can be directed to the creation of new assets that will increase both the cash flow and the net profit of the enterprise.
Additional cash flow leads to an increase in the value of the enterprise for investors and shareholders, which is one of the strategic objectives for the company's owners.
The effect of the financial leverage of the enterprise
The effect of financial leverage is the product of the differential (with a tax corrector) times the leverage. The figure below shows a diagram of the key links in the formation of the effect of financial leverage.
If you write down the three indicators included in the formula, then it will have next view:
where DFL is the effect of financial leverage;
T is the percentage rate of income tax;
ROA - return on assets of the enterprise;
r – interest rate on attracted (borrowed) capital;
D - borrowed capital of the enterprise;
E - equity capital of the enterprise.
So, let's analyze in more detail each of the elements of the effect of financial leverage.
tax corrector
The tax corrector shows how a change in the income tax rate affects the effect of financial leverage. Everyone pays income tax legal entities RF (LLC, OJSC, CJSC, etc.), and its rate may vary depending on the type of activity of the organization.
So, for example, for small enterprises engaged in the housing and communal sector, the final income tax rate will be 15.5%, while the unadjusted income tax rate is 20%. The minimum income tax rate by law cannot be lower than 13.5%.
Differential of financial leverage
The financial leverage differential (Dif) is the difference between the return on assets and the rate on borrowed capital. In order for the effect of financial leverage to be positive, it is necessary that the return on equity be higher than the interest on loans and borrowings.
With a negative financial leverage, the enterprise begins to suffer losses, because it cannot provide production efficiency higher than the payment for borrowed capital.
Differential value:
- Dif > 0 - The company increases the amount of profit received through the use of borrowed funds
- Dif = 0 - Profitability is equal to the interest rate on the loan, the effect of financial leverage is zero
Financial leverage ratio
The coefficient of financial leverage (analogue: the leverage of the financial leverage) shows what share in the total capital structure of the enterprise is occupied by borrowed funds (credits, loans, and other obligations), and determines the strength of the influence of borrowed capital on the effect of financial leverage.
Optimal leverage for the effect of financial leverage
On the basis of empirical data, the optimal leverage (debt-to-equity ratio) for an enterprise was calculated, which is 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: the possibility of losing financial independence, solvency and the risk of bankruptcy. If the amount of borrowed capital is less than 50%, the company misses the opportunity to increase profits. Optimal size the effect of financial leverage is considered to be a value equal to 30-50% of the return on assets (ROA).
Source: "finzz.ru"
Financial leverage ratio
To assess the financial stability of an enterprise in the long term, in practice, the indicator (coefficient) of financial leverage (CFL) is used. The financial leverage ratio is the ratio of borrowed funds of an enterprise to its own funds (capital). This coefficient is close to the coefficient of autonomy.
The concept of financial leverage is used in economics to show that, using borrowed capital, an enterprise forms a financial leverage to increase profitability and return on equity. The financial leverage ratio directly reflects the level of financial risk of the enterprise.
Formula for calculating the financial leverage ratio
Financial Leverage Ratio = Liabilities / Equity
By liabilities, various authors understand either the sum of short-term and long-term liabilities or only long-term liabilities. Investors and business owners prefer a higher leverage ratio because it provides a higher rate of return.
Lenders, on the contrary, invest in enterprises with a lower financial leverage ratio, since this enterprise is financially independent and has a lower risk of bankruptcy.
The financial leverage ratio is more accurately calculated not by the company's balance sheets, but by the market value of assets.
Since the value of an enterprise is often market value, the value of assets exceeds the book value, which means that the level of risk of this enterprise is lower than when calculating the book value.
Financial Leverage Ratio = (Long Term Liabilities + Short Term Liabilities) / Equity
Financial Leverage Ratio = Long-Term Liabilities / Equity
If the financial leverage ratio (CFL) is written by factors, then according to G.V. The Savitsky formula will look like this:
CFL = (Share of Debt in Total Assets) / (Share of Fixed Capital in Total Assets) / (Share of Working Capital in Total Assets) / (Share of Equity Working Capital in current assets) * Maneuverability of equity)
The effect of financial leverage (leverage)
The financial leverage ratio is closely related to the financial leverage effect, which is also referred to as financial leverage effects. The effect of financial leverage shows the rate of increase in the return on equity with an increase in the share of borrowed capital.
Leverage Effect = (1- Income Tax Rate) * (Gross Margin Ratio - Average Interest on a Company Loan) * (Amount of Borrowed Capital) / (Amount of Equity of a Company)
(1-Income tax rate) is a tax corrector - shows the relationship between the effect of financial leverage and various tax regimes.(Gross Margin Ratio - Average Interest on a Business Loan) represents the difference between the profitability of production and the average interest on loans and other liabilities.
(Amount of borrowed capital) / (Amount of own capital of an enterprise) is a coefficient of financial leverage (leverage) that characterizes the capital structure of an enterprise and the level of financial risk.
Normative values of the financial leverage ratio
The normative value in domestic practice is the value of the leverage ratio equal to 1, that is, equal shares of both liabilities and equity.
In developed countries, as a rule, the leverage ratio is 1.5, that is, 60% of debt and 40% of equity.
If the coefficient is greater than 1, then the company finances its assets at the expense of borrowed funds from creditors; if it is less than 1, then the company finances its assets from its own funds.
Also, the normative values of the financial leverage ratio depend on the industry of the enterprise, the size of the enterprise, the capital intensity of production, the period of existence, the profitability of production, etc. Therefore, the coefficient should be compared with similar enterprises in the industry.
Companies with a predictable cash flow for goods, as well as organizations with a high share of highly liquid assets, can have high values of the financial leverage ratio.
Source: "beintrend.ru"
Financial Leverage
The shoulder of the financial lever characterizes the strength of the impact of the financial leverage - this is the ratio between borrowed (SL) and own funds (SS).
The selection of these components allows you to purposefully manage the change in the effect of financial leverage in the formation of the capital structure.
So, if the differential has a positive value, then any increase in the financial leverage, i.e. an increase in the share of borrowed funds in the capital structure will lead to an increase in its effect.Accordingly, the higher the positive value of the financial leverage differential, the higher, other things being equal, its effect will be. However, the growth of the effect of financial leverage has certain limits, and it is necessary to realize the deep contradiction and inseparable connection between the differential and the leverage of financial leverage.
In the process of increasing the share of borrowed capital, the level of financial stability of the enterprise decreases, which leads to an increase in the risk of its bankruptcy. This forces lenders to increase the level of lending rates, taking into account the inclusion of an increasing premium for additional financial risk.
This increases the average calculated interest rate, which (at a given level of economic return on assets) leads to a reduction in the differential.
With a high value of the leverage of financial leverage, its differential can be reduced to zero, at which the use of borrowed capital does not increase the return on equity.
With a negative value of the differential, the return on equity will decrease, since part of the profit generated by equity capital will be spent on servicing the borrowed capital used at high interest rates for a loan. Thus, attracting additional borrowed capital is advisable only if the level of economic profitability of the enterprise exceeds the cost of borrowed funds.
The calculation of the effect of financial leverage allows you to determine the marginal limit of the share of the use of borrowed capital for a particular enterprise, to calculate the acceptable lending conditions.
Source: "center-yf.ru"
Degree of financial leverage (DFL) effect
The effect of financial leverage is an indicator that reflects the change in the return on equity obtained through the use of borrowed funds and is calculated using the following formula:
where DFL is the effect of financial leverage, in percent;
t is the income tax rate, in relative terms;
ROA — return on assets (economic profitability on EBIT) in %;
r — interest rate on borrowed capital, in %;
D - borrowed capital;
E - equity.
The effect of financial leverage is manifested in the difference between the cost of borrowed and allocated capital, which allows you to increase the return on equity and reduce financial risks.
The positive effect of financial leverage is based on the fact that the bank rate in a normal economic environment is lower than the return on investment. The negative effect (or the reverse side of financial leverage) occurs when the return on assets falls below the loan rate, which leads to accelerated loss formation.
Incidentally, the commonly held theory is that the US subprime crisis was a manifestation of the negative effect of financial leverage.
When the program of non-standard mortgage lending was launched, interest rates on loans were low, while real estate prices were growing. The low-income strata of the population were involved in financial speculation, since almost the only way for them to repay the loan was the sale of housing that had risen in price.
When housing prices crept down, and loan rates rose due to increasing risks (the leverage began to generate losses, not profits), the pyramid collapsed.
Calculation of the effect of financial leverage
The effect of financial leverage (DFL) is the product of two components adjusted by a tax factor (1 - t), which shows the extent to which the effect of financial leverage is manifested due to different levels of income tax.
One of the main components of the formula is the so-called financial leverage differential (Dif) or the difference between the return on the company's assets (economic profitability), calculated on EBIT, and the interest rate on borrowed capital:
Dif = ROA - r,
where r is the interest rate on borrowed capital, in %;
ROA - return on assets (economic profitability on EBIT) in%.
If the differential becomes less than zero, then the effect of financial leverage will only act to the detriment of the organization.
The second component of the effect of financial leverage is the coefficient of financial leverage (shoulder of financial leverage - FLS), which characterizes the strength of the impact of financial leverage and is defined as the ratio of borrowed capital (D) to equity (E):
Thus, the effect of financial leverage consists of the influence of two components: differential and leverage.
The differential and lever arm are closely interconnected. As long as the return on investment in assets exceeds the price of borrowed funds, i.e. the differential is positive, the return on equity will grow the faster, the higher the ratio of borrowed and own funds.
However, as the share of borrowed funds grows, their price rises, profits begin to decline, as a result, the return on assets also falls and, therefore, there is a threat of obtaining a negative differential.
According to economists, based on a study of the empirical material of successful foreign companies, the optimal effect of financial leverage is within 30-50% of the level of economic return on assets (ROA) with a financial leverage of 0.67-0.54. In this case, an increase in the return on equity is ensured not lower than the increase in the profitability of investments in assets.
The effect of financial leverage contributes to the formation of a rational structure of the sources of funds of the enterprise in order to finance the necessary investments and obtain the desired level of return on equity, in which the financial stability of the enterprise is not violated.
Using the above formula, we will calculate the effect of financial leverage.
The calculation results presented in the table show that by attracting borrowed capital, the organization was able to increase the return on equity by 9.6%.
Financial leverage characterizes the possibility of increasing the return on equity and the risk of loss of financial stability. The higher the share of borrowed capital, the higher the sensitivity of net income to changes in balance sheet profit. Thus, with additional borrowing, the return on equity may increase, provided:
if ROA > i, then ROE > ROA and ΔROE = (ROA - i) * D/E
Therefore, it is advisable to attract borrowed funds if the achieved return on assets ROA exceeds the interest rate for loan i. Then an increase in the share of borrowed funds will increase the return on equity.
However, at the same time, it is necessary to monitor the differential (ROA - i), since with an increase in the leverage of financial leverage (D / E), lenders tend to compensate for their risk by increasing the rate for the loan. The differential reflects the lender's risk: the larger it is, the lower the risk.
The differential should not be negative, and the effect of financial leverage should optimally be equal to 30-50% of the return on assets, since the stronger the effect of financial leverage, the higher the financial risk of loan default, falling dividends and share prices.
The level of associated risk characterizes the operational and financial leverage. Operating and financial leverage, along with the positive effect of increasing the return on assets and equity as a result of growth in sales and borrowings, also reflects the risk of lower profitability and incurring losses.
Source: "afdanalyse.ru"
Financial leverage (financial leverage)
Financial leverage (financial leverage) is the ratio of a company's borrowed capital to its own funds, it characterizes the degree of risk and stability of the company. The smaller the financial leverage, the more stable the position. On the other hand, borrowed capital allows you to increase the return on equity, i.e. earn additional return on equity.
An indicator that reflects the level of additional profit when using borrowed capital is called the effect of financial leverage. It is calculated using the following formula:
EGF \u003d (1 - Sn) × (KR - Sk) × ZK / SK,
where EFR is the effect of financial leverage, %.
Cn - income tax rate, in decimal terms.
KR - return on assets ratio (the ratio of gross profit to average cost assets), %.
Sk is the average interest rate for a loan, %. For a more accurate calculation, you can take the weighted average rate for the loan.
ZK - the average amount of borrowed capital used.
SC - the average amount of equity capital.
The formula for calculating the effect of financial leverage contains three factors:
- (1-Sn) - does not depend on the enterprise.
- (KR-SK) - the difference between the return on assets and the interest rate for a loan. It is called differential (D).
- (LC/SK) - financial leverage (FR).
Let's write the formula for the effect of financial leverage in short:
EGF \u003d (1 - Cn) × D × FR.
2 conclusions can be drawn:
- The effectiveness of the use of borrowed capital depends on the ratio between the return on assets and the interest rate for the loan. If the rate for a loan is higher than the return on assets, the use of borrowed capital is unprofitable.
- Ceteris paribus, greater financial leverage produces greater effect.
Source: "finances-analysis.ru"
Methods for calculating financial leverage
First way
The essence of financial leverage is manifested in the impact of debt on the profitability of the enterprise. Grouping expenses in the income statement into production and financial expenses allows us to identify two main groups of factors affecting profit:
- the volume, structure and efficiency of managing costs associated with the financing of current and non-current assets;
- the volume, structure and cost of sources of financing of the enterprise's funds.
Based on the profit indicators, the profitability indicators of the enterprise are calculated. Thus, the volume, structure and cost of funding sources affect the profitability of the enterprise. Enterprises resort to various sources of financing, including through the placement of shares or the attraction of loans and borrowings.
Attracting equity capital is not limited by any timeframe, so a joint-stock company considers the attracted funds of shareholders to be its own capital. Raising funds through loans and borrowings is limited to certain periods. However, their use helps to maintain control over the management of a joint stock company, which can be lost due to the emergence of new shareholders.
An enterprise can operate by financing its expenses only from its own capital, but no enterprise can operate solely on borrowed funds. As a rule, the enterprise uses both sources, the ratio between which forms the structure of the liability.The structure of liabilities is called the financial structure, the structure of long-term liabilities is called the capital structure. Thus, the capital structure is an integral part financial structure. Long-term liabilities that make up the capital structure and include equity and long-term borrowed capital are called fixed capital.
Capital structure = financial structure - short-term debt = long-term liabilities (constant capital).
When forming the financial structure (the structure of liabilities in general), it is important to determine:
- the ratio between long-term and short-term borrowings;
- the share of each of the long-term sources (own and borrowed capital) as a result of liabilities.
The use of borrowed funds as a source of asset financing creates the effect of financial leverage.
The effect of financial leverage: the use of long-term borrowed funds, despite their payment, leads to an increase in the return on equity.
The profitability of an enterprise is assessed using profitability ratios, including profitability ratios for sales, return on assets (profit/asset) and return on equity (profit/equity). The relationship between the return on equity and the return on assets indicates the importance of the company's debt.
Return on equity ratio (in the case of using borrowed funds) = profit - interest on debt repayment borrowed capital / equity capital.
The cost of debt can be expressed in relative and absolute terms, i.e. directly in interest accrued on a loan or loan, and in monetary terms - the amount of interest payments, which is calculated by multiplying the remaining amount of debt by the interest rate reduced to the period of use.
Return on assets = profit / assets.
Let's transform this formula to get the profit value:
Profit = return on assets assets.
Assets can be expressed in terms of the value of their funding sources, i.e. through long-term liabilities (the sum of own and borrowed capital):
Assets = equity + debt capital.
Substitute the resulting expression of assets into the profit formula:
Profit = return on assets (equity + debt).
And finally, we substitute the resulting expression of profit into the previously converted formula for return on equity:
Return on equity = return on assets (equity + debt) - interest on debt repayment debt capital / equity capital.
Return on equity \u003d return on assets equity + return on assets borrowed capital - interest on debt repayment borrowed capital / equity capital.
Return on equity \u003d return on assets equity + debt (ROA - interest on debt) / equity.
Thus, the value of the return on equity ratio increases with the growth of debt as long as the value of the return on assets is higher than the interest rate on long-term borrowed funds. This phenomenon is called the effect of financial leverage.For an enterprise that finances its activities only from its own funds, the return on equity is approximately 2/3 of the return on assets; an enterprise using borrowed funds has 2/3 of the return on assets plus the effect of financial leverage.
At the same time, the return on equity increases or decreases depending on the change in the capital structure (the ratio of own and long-term borrowed funds) and the interest rate, which is the cost of attracting long-term borrowed funds. This is where financial leverage comes into play.
Quantitative assessment of the impact of financial leverage is carried out using the following formula:
Strength of financial leverage = 2/3 (return on assets - interest rate on loans and borrowings) (long-term debt / equity).
It follows from the above formula that the effect of financial leverage occurs when there is a discrepancy between the return on assets and the interest rate, which is the price (cost) of long-term borrowed funds. In this case, the annual interest rate is reduced to the period of use of the loan and is called the average interest rate.
Average interest rate = the sum of interest on all long-term credits and loans for the analyzed period / the total amount of attracted credits and loans in the analyzed period 100%.
The formula for the effect of financial leverage includes two main indicators:
- the difference between the return on assets and the average, interest rate, called the differential;
- the ratio of long-term debt to equity, called the leverage.
Based on this, the formula for the effect of financial leverage can be written as follows:
The force of financial leverage = 2/3 of the leverage differential.
After taxes are paid, 2/3 of the differential remains. The formula for the impact of financial leverage, taking into account taxes paid, can be represented as follows:
The strength of the impact of financial leverage = (1 - profit tax rate) 2/3 of the differential x leverage.
It is possible to increase the profitability of own funds through new borrowings only by controlling the state of the differential, the value of which can be:
- positive if the return on assets is higher than the average interest rate (the effect of financial leverage is positive);
- equal to zero if the return on assets is equal to the average interest rate (the effect of financial leverage is zero);
- negative if the return on assets is below the average interest rate (the effect of financial leverage is negative).
Thus, the value of the return on equity will increase as borrowed funds increase until the average interest rate becomes equal to the value of the return on assets.
At the moment of equality of the average interest rate and the return on assets, the leverage effect will “turn over”, and with a further increase in borrowed funds, instead of increasing profits and increasing profitability, there will be real losses and unprofitability of the enterprise.
Like any other indicator, the level of financial leverage effect should have an optimal value.
It is believed that the optimal level is 1/3 - 2/3 of the value of return on assets.
Second way
By analogy with the production (operational) leverage, the impact force of the financial leverage can be defined as the ratio of the rate of change in net and gross profit:
The strength of the impact of financial leverage is the rate of change in net profit / the rate of change in gross profit.
In this case, the strength of the impact of financial leverage implies the degree of sensitivity of net profit to changes in gross profit.
Third way
Financial leverage can also be defined as the percentage change in net income per ordinary share outstanding due to a change in the net result of operating the investment (earnings before interest and taxes):
Strength of financial leverage = percentage change in net profit per ordinary share in circulation / percentage change in the net result of investment exploitation.
Consider the indicators included in the formula of financial leverage.
The concept of earnings per ordinary share in circulation:
Net income ratio per share outstanding = net income - amount of dividends on preferred shares / number of ordinary shares outstanding.
Number of common shares in circulation = total number of common shares outstanding - treasury common shares in the company's portfolio.
Earnings per share is one of the most important indicators affecting the market value of the company's shares. However, it must be remembered that:
- profit is an object of manipulation and, depending on the methods used accounting can be artificially overestimated (FIFO method) or underestimated (LIFO method);
- The direct source of dividend payments is not profit, but cash;
- By buying up its own shares, the company reduces their number in circulation, and therefore increases the amount of profit per share.
The concept of the net result of the operation of the investment. Western financial management uses four main indicators that characterize the financial performance of an enterprise:
- added value;
- gross result of exploitation of investments;
- net result of exploitation of investments;
- return on assets.
Added value
Value added (NA) is the difference between the cost of manufactured products and the cost of consumed raw materials, materials and services:
Value added \u003d cost of manufactured products - cost of consumed raw materials, materials and services.
In its economic essence, value added represents that part of the value of the social product that is newly created in the production process. Another part of the value of the social product is the cost of raw materials, materials, electricity, work force etc.
Gross result of exploitation of investments
The Gross Result of Exploitation of Investments (BREI) is the difference between value added and labor costs (direct and indirect). Overspending tax may also be deducted from the gross result wages:
Gross result of exploitation of investments = value added - expenses (direct and indirect) for wages - tax on wage overruns.
The gross result of investment exploitation (BREI) is an intermediate indicator of the financial performance of an enterprise, namely, an indicator of the sufficiency of funds to cover the costs taken into account in its calculation.
Net result of exploitation of investments
The net operating result of an investment (NREI) is the difference between the gross operating result of an investment and the cost of restoring fixed assets. In its economic essence, the gross result of the exploitation of investments is nothing more than profit before interest and taxes.
In practice, the balance sheet profit is often taken as the net result of the operation of investments, which is wrong, since the balance sheet profit (profit transferred to the balance sheet) is profit after paying not only interest and taxes, but also dividends:
Net result of the operation of investments = gross result of the operation of investments - the cost of restoring fixed assets (depreciation).
Return on assets
Profitability is the ratio of the result to the funds spent. The return on assets (RA) is understood as the ratio of profit before interest and taxes to assets - the funds spent on the production of products:
Return on Assets = (net return on investment / assets) 100%
Transforming the formula for return on assets will allow you to obtain formulas for the profitability of sales and asset turnover. To do this, we use a simple mathematical rule: multiplying the numerator and denominator of a fraction by the same number will not change the value of the fraction. Multiply the numerator and denominator of the fraction (return on assets) by the volume of sales and divide the resulting figure into two fractions:
Return on assets = (net result of operation of investments sales volume / assets sales volume) 100% = (net result of operation of investments / sales volume) (sales volume / assets) 100%.
The resulting formula for return on assets as a whole is called the Dupont formula. The indicators included in this formula have their names and their meaning. The ratio of the net result of the operation of investments to the volume of sales is called the commercial margin. In essence, this coefficient is nothing but the coefficient of profitability of the implementation.The indicator "sales volume / assets" is called the transformation ratio, in essence, this ratio is nothing more than the asset turnover ratio. Thus, the regulation of the return on assets is reduced to the regulation of the commercial margin (sales profitability) and the transformation ratio (asset turnover).
But back to financial leverage. Let us substitute the formulas for net profit per ordinary share in circulation and the net result of the operation of investments into the formula for the force of financial leverage:
The strength of the impact of financial leverage - percentage change in net income per ordinary share in circulation / percentage change in the net result of the operation of investments = (net profit - the amount of dividends on preferred shares / the number of ordinary shares in circulation) / (net result of the operation of investments / assets) 100%.
This formula makes it possible to estimate by what percentage the net profit per one ordinary share in circulation will change if the net result of investment operation changes by one percent.
The coefficient of financial leverage (financial leverage) gives an idea of the real ratio of own and borrowed funds in the enterprise. Based on the data on the financial leverage ratio, one can judge the stability of the economic entity, the level of its profitability.
What does financial leverage mean
The financial leverage ratio is often called financial leverage, which is able to influence the profit level of the organization by changing the ratio of own and borrowed funds. It is used in the process of subject analysis economic relations to determine the level of its financial stability in the long term.
The values of the financial leverage ratio help the company's analysts to identify additional potential for profitability growth, assess the degree of possible risks and determine the dependence of the level of profit on external and internal factors. With the help of financial leverage, it is possible to influence the net profit of the organization by managing financial liabilities, and there is also a clear idea of the appropriateness of using credit funds.
Types of financial leverage
According to the efficiency of use, there are several types of financial leverage:
- Positive. It is formed when the benefit from raising borrowed funds exceeds the fee (interest) for using the loan.
- Negative. It is typical for a situation where the assets acquired by obtaining a loan do not pay off, and the profit is either absent or below the listed percentages.
- Neutral. Financial leverage, at which the income from investments is equivalent to the costs of obtaining borrowed funds.
Financial Leverage Formulas
The financial leverage ratio is the ratio of debt to equity. The calculation formula is as follows:
FL = ZK / SK,
where: FL is the financial leverage ratio;
ZK - borrowed capital (long-term and short-term);
SC is equity capital.
This formula also reflects the financial risks of the enterprise. The optimal value of the coefficient ranges from 0.5-0.8. With such indicators, it is possible to maximize profits with minimal risks.
For some organizations (trading, banking), a higher value is acceptable, provided that they have a guaranteed cash flow.
Most often, when determining the level of the coefficient value, they use not the book (accounting) cost of equity, but the market value. The indicators obtained in this case will most accurately reflect the current situation.
More detailed version formula for the financial leverage ratio is as follows:
FL \u003d (GK / SA) / (IK / SA) / (OA / IK) / (OK / OA) × (OK / SK),
where: ZK is borrowed capital;
SA is the sum of assets;
IC is invested capital;
ОА is current assets;
OK is working capital;
SC is equity capital.
The ratio of indicators presented in brackets has the following characteristics:
- (ZK / SA) is the coefficient of financial dependence. The lower the ratio of borrowed capital to total assets, the more stable the company financially.
- (IC / SA) is a coefficient that determines the financial independence of a long-term nature. The higher the score, the more stable the organization.
- (OA / IC) is the coefficient of maneuverability of the IC. Preferably, its lower value, which determines financial stability.
- (OK / ОА) is the coefficient of provision with working capital. High rates characterize the greater reliability of the company.
- (OK / SC) is the SC maneuverability coefficient. Financial stability increases with decreasing coefficient.
Example 1
The company at the beginning of the year has the following indicators:
- ZK - 101 million rubles;
- SA - 265 million rubles;
- OK - 199 million rubles;
- OA - 215 million rubles;
- SK - 115 million rubles;
- IC - 118 million rubles.
Calculate the financial leverage ratio:
FL = (101 / 265) / (118 / 265) / (215 / 118) / (199 / 215) × (199 / 115) = 0.878.
Or FL \u003d ZK / SK \u003d 101 / 115 \u003d 0.878.
On the conditions characterizing the profitability of the IC (own capital), big influence has the amount of borrowed funds. The value of the profitability of the equity capital (equity) is determined by the formula:
RSK = CHP / SK,
NP is net profit;
For detailed analysis the financial leverage ratio and the reasons for its changes, all 5 indicators included in the considered formula for its calculation should be considered. As a result, the sources will be clear due to which the indicator of financial leverage has increased or decreased.
The effect of financial leverage
Comparison of indicators of the financial leverage ratio and profitability as a result of the use of SC (own capital) is called the effect of financial leverage. As a result, you can get an idea of how the profitability of the insurance company depends on the level of borrowed funds. The difference between the cost of return on assets and the level of receipt of funds from the outside (that is, borrowed) is determined.
- IA is gross income or profit before tax and interest;
- PSP - profit before taxes, reduced by the amount of interest on loans.
The PD indicator is calculated as follows:
VD \u003d C × O - I × O - PR,
where: C - average price manufactured products;
O is the output volume;
And - costs based on 1 unit of goods;
ETC - fixed costs for production.
The effect of financial leverage (EFL) is considered as the ratio of profit indicators before and after interest payments, that is:
EFL \u003d VD / PSP.
In more detail, EFL is calculated based on the following values:
EFL \u003d (RA - CZK) × (1 - SNP / 100) × ZK / SK,
where: RA - return on assets (measured as a percentage excluding taxes and interest on the loan payable);
CPC is the cost of borrowed funds, expressed as a percentage;
SNP is the current income tax rate;
ZK is borrowed capital;
SC is equity capital.
Return on assets (RA) as a percentage, in turn, is equal to:
RA = IA / (SC + SC) × 100%.
Example 2
Calculate the effect of financial leverage using the following data:
- IA \u003d 202 million rubles;
- SC = 122 million rubles;
- ZK = 94 million rubles;
- CZK = 14%;
- SNP = 20%.
Using the formula EFL \u003d EFL \u003d (RA - CZK)× (1 - SNP / 100)× ZK / SK, we get the following result:
EFL = (202 / (122 + 94)× 100) - 14,00)% × (1 - 20 / 100) × 94 / 122= (93,52% - 14,00%) × (1 - 0,2) × 94 / 122 =79,52% × 0,8 × 94 / 122 = 49,01%.
Example 3
If, under the same conditions, there is an increase in borrowed funds by 20% (up to 112.8 million rubles), then the EFL indicator will be equal to:
EFL = (202 / (122 + 112.8)× 100 - 14,00)% × (1 - 20 / 100) × 112,8 / 122 = (86,03% - 14,00%) × 0,8 × 112,8 / 122 = 72,03% × 0,8 × 112,8 / 122 = 53,28%.
Thus, by increasing the level of borrowed funds, it is possible to achieve more high rate EFL, that is, to increase the return on equity by attracting borrowed funds. At the same time, each company conducts its own assessment of financial risks associated with difficulties in repaying credit obligations.
The factors characterizing the return on equity are also affected by the factors of attracting borrowed funds. The formula for determining the return on equity will be:
RSK = CHP / SK,
where: RSK - return on equity;
NP is net profit;
SC is the amount of own capital.
Example 4
The balance sheet profit of the organization amounted to 18 million rubles. The current income tax rate is 20%, the amount of the SC is 22 million rubles, the GC (attracted) is 15 million rubles, the amount of interest on the loan is 14% (2.1 million rubles). What is the profitability of the IC with and without borrowed funds?
Solution 1 . Net profit (NP) is equal to the sum of balance sheet profit minus the cost of borrowed funds (interest equal to 2.1 million rubles) and income tax from the remaining amount: (18 - 2.1)× 20% = 3.18 million rubles.
PE \u003d 18 - 2.1 - 3.18 \u003d 12.72 million rubles.
The profitability of the IC in this case will have the following value: 12.72 / 22× 100% = 57,8%.
Solution 2 The same indicator without attracting funds from outside will be equal to 14.4 / 22 = 65.5%, where:
NP = 18 - (18× 0.2) = 14.4 million rubles.
Results
Analyzing the data of indicators of the financial leverage ratio and the effect of financial leverage, it is possible to manage the enterprise more effectively, based on attracting a sufficient amount of borrowed funds, without going beyond conditional financial risks. The formulas and examples given in our article will help you calculate the indicators.
Any commercial activity is associated with 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, attraction external funding associated with the payment of interest for its use. Therefore, with negative economic indicators(for example, with a decrease in sales, personnel problems, etc.), the company may have an unsustainable debt burden. At the same time, the price for additionally attracted capital will increase.
Financial occurs when the company uses borrowed funds. Normal is the situation in which the payment for borrowed capital is less than the profit that it brings. When adding this additional profit to the income received from equity, an increase in profitability is noted.
In the commodity and stock market, financial leverage is a margin requirement, i.e. the ratio of the deposit amount to the total value of the transaction. This ratio is called leverage.
The financial 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 amount 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 from 0.5 to 0.8. A high value of the coefficient can be afforded by companies that have a stable and well-predictable dynamics of financial indicators, as well as enterprises with a high share of liquid assets - trading, marketing, banking.
The effectiveness of borrowed capital largely depends on the return on assets and the loan interest rate. If the profitability is below the rate, then it is unprofitable to use 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 increases equity capital when using borrowings.
There is an effect of financial leverage due to the difference between the return on assets and the cost of borrowed funds. For its calculation, a multifactorial model is used.
The calculation formula is as follows 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 price of borrowed capital, %; EC - average annual amount of own capital; LC - average annual amount of borrowed capital; RP - income tax rate, %. The recommended value of this indicator is in the range from 0.33 to 0.5.
The effect of financial leverage
The financial risk of an enterprise is primarily due to the structure of the sources of its property, i.e. the ratio of own and borrowed capital attracted to finance its activities. Almost all funds are attracted by the enterprise on a reimbursable basis, however, the obligations for their various sources are not the same: if the company fails to fulfill its obligations to external investors, they may initiate bankruptcy proceedings. Therefore, the essence of financial risk lies in the fact that a high proportion of borrowed capital increases the risk of the company's inability to pay off its obligations and, as a result, its possible bankruptcy. On the other hand, raising borrowed funds allows the company to receive additional profit on equity.
To characterize the relationship between the profit of an enterprise, the cost of resources spent on its receipt and the costs incurred in connection with attracting and maintaining the formed structure of enterprise financing sources, a special economic category is used - leverage (lever).
Leverage (leverage - the action of the lever, force, means to achieve the goal) is a long-term operating factor, the value of which can be controlled; even a small change can lead to a significant change in the resulting performance of the company.
The financial lever characterizes the use of borrowed funds by the enterprise, which affects the change in the return on equity ratio; arises with the advent of borrowed funds in the composition used by the enterprise and is closely related to the category of financial risk of the company.
There are various approaches to the definition of financial leverage.
1. The actual coefficient of financial leverage (2.6) - characterizes the ratio of borrowed and own funds of the enterprise, the higher its value, the more borrowed capital falls on each ruble of its own, and the higher the financial risk of the company.
2. The European approach considers financial leverage as an indicator that reflects the level of additionally generated profit on equity when an enterprise uses borrowed funds. It is called the effect of financial leverage and is calculated using the following formula:
where EGF 1 is the effect of financial leverage, calculated by the first method (European approach);
C n.p - income tax rate, expressed as a decimal fraction;
ER A - economic profitability of assets, calculated according to the formula (2.14) and expressed in%;
SP - the average interest rate on loans, expressed in%;
ЗК av - the average amount of borrowed capital used by the enterprise;
SC av - the average amount of equity capital of the enterprise.
Numerically, EGF 1 is equal to the increase in the net return on equity in the transition from a debt-free financing option to the capital structure that has developed for the period under review. Its positive value indicates that the attraction of borrowed capital allows the company to increase the return on equity. At the same time, its negative or very large value indicates high level financial risk.
The formula for the effect of financial leverage (3.12) has three components.
· Tax corrector of financial leverage (1 - C n.p.) - characterizes the extent to which the effect of financial leverage is manifested in connection with different levels of income taxation. Its value practically does not depend on the activity of the enterprise, since the income tax rate is established by law. At the same time, in the process of managing financial leverage, a differentiated tax corrector can be used in the following cases:
If by various types the activities of the enterprise established differentiated rates of taxation of profits;
If by certain types activities, the company uses tax benefits on profits;
If individual subsidiaries of the enterprise operate in free economic zones, where there is a preferential regime for profit taxation;
If individual subsidiaries of the enterprise operate in states with a lower level of income taxation.
In these cases, by influencing the sectoral or regional structure of production (and, accordingly, the composition of profit in terms of its taxation level), it is possible, by reducing the average profit tax rate, to increase the impact of the tax corrector on the effect of financial leverage.
Financial leverage differential (ER A - SP) - characterizes the difference between the gross return on assets and the average interest rate for a loan, is the main condition that forms it positive effect. If the additional profit received by the enterprise when using borrowed funds exceeds the financial costs that it incurs when using borrowed capital, then the value of this indicator is positive. The higher the positive value of the financial leverage differential, the higher its effect will be.
Due to the high dynamism of this indicator, it requires constant monitoring in the process of managing the effect of financial leverage. This dynamism is due to a number of factors.
During a period of deterioration in the financial market (with a reduction in the supply of capital), the cost of borrowed funds may increase sharply, exceeding the level of gross profit generated by the assets of the enterprise;
A decrease in the financial stability of an enterprise with an increase in the share of borrowed capital used leads to an increase in the risk of its bankruptcy, which forces creditors to increase the interest rate for a loan, taking into account the risk premium; at a certain level of the general interest rate for a loan, the financial leverage differential can become zero (when the use of borrowed capital does not increase the return on equity) or negative (when the return on equity decreases, since part of the net profit generated by equity capital will be spent on servicing the used borrowed capital at high interest rates);
During the period of deterioration in the commodity market, the volume of sales of products is reduced, and, accordingly, the size of the gross profit of the enterprise from operating activities; under these conditions, the negative value of the differential of financial leverage can be formed even at constant interest rates for a loan due to a decrease in the economic profitability ratio of assets.
The formation of a negative value of the financial leverage differential for any of the above reasons leads to a decrease in the return on equity ratio. In this case, the use of borrowed capital by the enterprise has a negative effect, and therefore unprofitable.
· The coefficient of financial leverage or its leverage (LC cf / SC cf) - characterizes the amount of borrowed capital used by the enterprise, per unit of equity capital, is the factor that enhances the positive or negative effect obtained due to the corresponding value of its differential. At positive value differential, any increase in the coefficient of financial leverage will cause an even greater increase in the return on equity ratio, and with a negative value of the differential, to an even greater rate of its decline. In other words, an increase in the coefficient of financial leverage causes an even greater increase in its effect (positive or negative, depending on the positive or negative value of the differential).
With a constant differential, the leverage ratio is the main generator of both the increase in return on equity and the financial risk of losing this profit.
Formula (3.12) is classical and does not take into account the singularities Russian taxation. As noted above, financial costs, according to the current Tax Code, are divided into two categories: attributable to costs and financial results. In this regard, the formula for the effect of financial leverage adapted to Russian tax conditions is as follows
where SP c - the interest rate on borrowed capital, attributable to the cost of production;
SP p - interest rate on borrowed capital, attributable to financial results (profit).
3. The American approach to assessing the effect of financial leverage (also called the level of financial leverage) is to highlight its impact on the amount of net profit, namely, how sensitive net profit is to changes in operating profit (NREI). The result is defined as the ratio of the rate of change in net profit in the current period relative to the previous one, expressed as a percentage, to the same rate of change in operating profit:
, (3.14)
where EGF 2 is the effect of financial leverage, calculated by the second method (American approach);
PE (%) = (PE 1 - PE 0) / PE 0 × 100% - the rate of change in net profit in the current period compared to the previous one,%;
NREI (%) = (NREI 1 - NREI 0) / NREI 0 × 100% - the rate of change in operating profit in the current period relative to the previous one, %.
The value of EGF 2 shows how many percent net profit will change if operating profit changes by 1%. The greater the amount of financial costs that the company incurs on borrowed capital, the more the net and operating profits will differ, the more significantly the net profit will change when operating, which means that the effect of financial leverage will be higher. In this case, it is a measure of financial risk, its high value indicates significant financial costs to the firm.
Transformation of formula (3.14) gives the classical EGF 2 formula:
, (3.15)
where BP is the balance sheet profit (profit before tax) of the enterprise.
Formula (3.15) is also not quite adapted to the Russian financial management. The modified formula for the effect of financial leverage is as follows
. (3.16)
Knowledge of the mechanism of the impact of financial leverage on the level of profitability of equity and the level of financial risk allows you to purposefully manage both the cost and the capital structure of the enterprise.
test questions
1. What is the financial risk of the enterprise? What types of risks exist and why do they arise?
2. What is the main goal and objectives of management financial risks?
3. Describe the procedure for managing the financial risks of the enterprise.
4. What are the main methods used to assess financial risks? Is there a universal one among them? Justify your answer.
5. What are the ways to neutralize financial risks? What are the advantages and disadvantages of external and internal mechanisms for their neutralization?
6. List the main ways of external financing of the enterprise. What are the benefits of each?
7. What are the risks associated with different external funding sources?
8. How and for what purpose are the operating profit threshold and financial critical point calculated?
9. Define the concept of leverage (lever). In this connection, in the course of the enterprise's activity, the concept of financial leverage arises?
10. What are the approaches to determining the numerical value of financial leverage?
