The financial leverage ratio (leverage) is used to display the real picture of the ratio of funds in an enterprise - own and borrowed funds. Based on the information obtained, one can judge the level of profitability of an economic entity and its sustainability.
The meaning of financial leverage
The ratio under consideration is often called financial leverage, which can influence the level of profit of an enterprise by changing the proportions of equity and borrowed funds.
The coefficient can be used as part of the analysis of the subject economic relations to establish the level of sustainability for the long term. The value of the coefficient is taken into account by enterprise analysts when identifying additional potential for profitability growth, assessing the degree of possible risks and determining the dependence of the profit level on various factors (internal and external).
The higher this indicator, the greater the likelihood of a business risk for the enterprise. A large share of borrowed funds means less profit for the enterprise: part of it will be used to repay loans and pay interest.
With the help of financial leverage, you can influence the net profit of an enterprise, manage financial liabilities and draw conclusions regarding the rational use of credit funds.
An enterprise, the majority of whose liabilities are borrowed funds, is considered financially dependent. The capitalization ratio in this case will be high. And vice versa: an enterprise that finances its own activities with its own funds is considered financially independent. The capitalization rate here will be low.
What are the different types of financial leverage?
Taking into account the efficiency of use, financial leverage can be:
- positive – occurs if the amount of benefit received from attracting borrowed funds is higher than the fee (interest) for using the loan product;
- negative - typical for a situation where assets, the acquisition of which is directly related to obtaining a loan, do not pay off, and the profit is either completely absent or is lower than the listed interest;
- neutral – when income from investments is equal to the costs of obtaining borrowed funds.
Formula for calculation: optimal value
To determine the ratio of borrowed and equity funds, use the following formula:
FL = ZK:SK,
- where ZK is borrowed capital (short-term or long-term),
- SC – available capital (own).
The application of this formula will help reflect the financial risks for the enterprise. The optimal coefficient value is considered to be varying from 0.5 to 0.8. For an enterprise, this means the opportunity to increase profits with minimal risks.
At the same time, for individual enterprises (trade, banking), a higher value of the coefficient is allowed with the proviso that they have a guaranteed source of funds.
Often, when establishing the value of the coefficient, the market value is used instead of the balance sheet (accounting) value of equity capital. The indicators obtained in this case can most accurately reflect the current situation.
In a detailed analysis of the coefficient under consideration and the reasons that determined its changes, it is recommended to consider 5 indicators that are included in the corresponding formula for its calculation. These are invested capital, total assets, working capital and assets, equity. As a result, the sources due to which the indicator has changed upward or downward will become clear.
Financial leverage effect
The process of comparing the indicators of the ratio under consideration with profitability (the result of using equity capital) is called the “financial leverage effect.”
As a result, it is possible to achieve an idea of how the efficiency of equity capital depends on borrowed funds. The difference is established between the value of return on assets and the level of incoming funds from outside, i.e. borrowed funds.
To calculate the final effect of financial leverage, the following indicators are used:
- PSP – profit before taxes, reduced by the amount of interest on credit products;
- VT – gross income or profit before interest and taxation.
The effect of financial leverage should be considered as the ratio of the amount of profit before and after interest payments:
EFL = VD:PSP.
The coefficient under consideration is important for investors who consider this enterprise as a potential investment. The latter are attracted, in particular, to companies where equity capital predominates. However, the leverage ratio cannot be too low as this may affect the percentage of their own profits received in the form of interest, i.e. reduce it.
Definition
Financial leverage ratio(debt-to-equity ratio) is an indicator of the ratio of debt and equity capital of an organization. It belongs to the group of the most important indicators of the financial position of an enterprise, which includes similar in meaning coefficients of autonomy and financial dependence, which also reflect the proportion between the organization’s own and borrowed funds. The term "financial leverage" is often used in more in a general sense, speaking about a principled approach to business financing, when, with the help of borrowed funds, the enterprise forms financial leverage to increase the return on its own funds invested in the business.
Calculation (formula)
The financial leverage ratio is calculated as the ratio of debt to equity:
Financial leverage ratio = Liabilities / Equity
Both the numerator and the denominator are taken from the liability side of the organization's balance sheet. Liabilities include both long-term and short-term liabilities (i.e., whatever remains after subtracting equity from the balance sheet).
Normal value
Optimal, especially in Russian practice, is considered to be an equal ratio of liabilities and equity capital ( net assets), i.e. the financial leverage ratio is equal to 1. A value of up to 2 may be acceptable (for large public companies this ratio may be even higher). At large values coefficient, the organization loses financial independence, and its financial position becomes extremely unstable. It is more difficult for such organizations to attract additional loans. The most common coefficient value in developed economies is 1.5 (ie 60% debt and 40% equity).
A too low value of the financial leverage ratio indicates a missed opportunity to use financial leverage - to increase equity capital by involving borrowed funds in activities.
Like other similar coefficients characterizing the capital structure (, coefficient of financial dependence), the normal value of the financial leverage coefficient depends on the industry, the scale of the enterprise and even the method of organizing production (capital-intensive or labor-intensive production). Therefore, it should be assessed over time and compared with the indicators of similar enterprises.
Financial leverage, or, as it is also called, financial leverage is a certain ratio of borrowed capital to the company’s own financial resources. This indicator allows you to assess the degree of stability and risk of the company. The lower its value, the more stable the company feels in current market conditions. However, the opportunity to take out a loan means for any company solving problems that have arisen and obtaining additional profit, that is, an increase in profitability.
The name of this term came to us from in English, the word “leverage” can be translated as leverage or a means of achieving results. This is a certain factor; its slight fluctuations have a significant impact on the indicators that are associated with it.
Attracting borrowed capital is always associated with a certain amount of risk. Why do enterprises go for this, since they can completely get by with their own funds? The fact is that financial leverage allows you to obtain additional profit, provided that the return on total capital is greater than the return on borrowed capital. The more capital a firm's top managers have at their disposal, the wider the range of investment opportunities. However, you should always remember that, unlike dividends, payments for the use of raised funds must be made on time and in full.
Own funds are the amount of issued and paid shares calculated at the nominal price, plus retained earnings and other accumulated reserves along with additional capital, if any, of the enterprise.
The coefficient that determines financial leverage is often calculated using a 5-factor model:
CFL = (borrowed capital/total assets) : (fixed capital/total assets) : (current assets/fixed capital) : (equity value working capital/ current assets)
IN Russian theory Financial leverage, depending on the data source, is assessed using one of several methods:
1. According to accounting data.
In this case, only long-term loans are taken into account, and short-term loans are not taken into account. The critical value of the coefficient is equal to one, and a zero value indicates that the enterprise manages mainly with its own funds.
2. Based on tax reporting(Profits and Losses Report).
This method uses two formulas depending on whether historical data is available for the calculation. If yes, then the calculation is performed like this:
FL = ∆ChP/∆OP, where
FL - financial leverage;
∆NP - change in net profit;
∆OP - change in operating profit.
If historical data is not available, then the following formula is used:
DFL = OP/(OP-P), where
DFL - financial leverage;
OP - operating profit;
P - the amount of interest on loans and borrowings.
The minimum value of the indicator calculated using this method is equal to one.
In this case, the amount of all liabilities is included in the debt capital, regardless of the period.
KR - profitability ratio of all assets of the company, %.
Sk - average value of the interest rate on the loan, %.
ZK - the value of borrowed capital.
SK is the value of equity capital.
Conventionally, net profit can be represented as the difference between revenue and expenses of two types - production and financial. They are not interchangeable, but the amount and share of each of these types of expenses can be controlled.
The amount of net profit depends on many factors. From the position financial management by the activities of the enterprise it is influenced by:
a) how rationally the financial resources provided to the enterprise are used;
b) structure of sources of funds.
The first point is reflected in the volume and structure of fixed and working capital and the efficiency of their use. Investment in fixed assets is accompanied by an increase in the share fixed costs(depreciation). Changing the relationship between constants and variable expenses can significantly affect profit margins. This relationship is characterized by the category of production leverage. Its level is higher, the higher the share of fixed expenses.
The second point is reflected in the ratio of own and borrowed funds as sources of long-term financing, the feasibility and efficiency of using the latter.
Attracting one source or another financial resources is associated with certain costs: shareholders need to pay dividends, banks - interest for using a loan, etc. The total amount of funds that must be paid for using a certain volume of financial resources, expressed as a percentage of this volume, is called the price of capital.
Depending on the duration of existence in this particular form, the sources of financial resources of an enterprise can be divided into short-term and long-term. Under normal conditions, it is assumed that long-term investments are financed by long-term sources of financing (equity and long-term bank loans), and current assets, mainly by short-term liabilities.
When determining the price of capital, economists agree that the main sources taken into account when determining the weighted average cost of capital WACC (Weighted Average Cost of Capital) are equity and long-term borrowed capital.
Regarding the accounting of accounts payable and short-term bank loans, there are different opinions. So E.S. Stoyanova includes them in the WACC calculation.
V.V. Kovalev excludes them from the calculation, J. Brigham and L. Gapenski believe that “the relevant components of capital, essential for calculating its price,” are:
1) part of short-term loans and borrowings, which represents permanent source of financing,
2) long-term loans,
3) own capital.
Indeed, WACC is used in calculating long-term investment projects, i.e. is determined over a long period, therefore short-term sources of financial resources are accounts payable and short-term bank loans attracted to cover cyclical or seasonal fluctuations in working capital - should not be taken into account when calculating it. Short-term bank loans used as a permanent source of financing must be taken into account in the process of estimating the cost of capital.
Because the cost various elements capital is different, the problem of choosing sources of financial resources arises. And here the main argument in favor of choosing one or another source is to compare the costs of them. By attracting cheap debt capital, the owner of equity capital can significantly increase the return on equity (this increased return is compensation for increased risk). When attracting borrowed capital, financial leverage comes into play. Attracting borrowed funds under certain conditions allows you to increase the return on invested own funds, i.e. ensure that the return on equity exceeds the return on assets. Attracting debt capital makes sense if its cost is lower than the expected return on assets.
Financial leverage is the potential opportunity to influence an organization's profit by changing the volume and structure of long-term liabilities.
Among the indicators for assessing the level of financial leverage, two are most famous:
Debt to equity ratio;
The ratio of the rate of change in net profit to the rate of change in profit before taxes and interest.
Financial leverage characterizes the organization's use of borrowed funds, which affect the measurement of the return on equity ratio. Financial leverage is an objective factor that arises with the appearance of borrowed funds in the amount of capital used by an organization, allowing it to obtain additional profit on its own capital.
The level of financial leverage characterizes the sensitivity and ability to manage net profit. The higher the leverage value, the more nonlinear the relationship (sensitivity) becomes between changes in net profit and profit before taxes and interest, and therefore, the greater the risk of not receiving it. The level of financial leverage increases with an increase in the share of borrowed capital and, accordingly, the amount of interest paid on the loan, which characterizes the activity of financial activity. However, as the level of financial leverage increases, financial risk increases.
Financial leverage is not only an indicator of financial stability, but also has big influence to increase or decrease the amount of net profit and return on equity of the organization.
The effect of financial leverage is manifested in the fact that an increase in the share of borrowed funds leads to an increase in return on equity, but at the same time there is an increase in the degree of financial risk, i.e. an alternative between risk and expected return arises. Therefore, financial managers need to adjust the ratio of equity and debt capital (and, accordingly, the effect of financial leverage) to the optimal one.
As for the logic of forming indicators, for the first indicator it boils down to the fact that any source of funds for the organization is paid. The whole question is the size and methods of this board. However, borrowed sources have, as V.V. Kovalev put it, one unpleasant feature: although their cost is usually lower compared to the cost of sources of own funds, however, payment for their use is mandatory, regardless of whether the organization operates profitably or unprofitably. Additional attraction of borrowed capital is usually characterized by an increase in the level of financial leverage, that is, an increase in the financial risk of the organization’s activities and an increase in the rate of return required by the owners.
In other words, the organization should have approximately equal numbers of its own and attracted sources, the lever should be at rest. Otherwise, when there are more borrowed sources, since they are all paid, that is, the end of the lever with borrowed sources moves significantly down and the so-called “baton effect” occurs, the consequence of which is a significant deterioration in the financial position of the organization. The higher the percentage of attracted sources, the lower the organization’s net profit. Thus, the higher the level of financial leverage, the higher the financial risk of the organization. The positive impact of financial leverage will be provided that the economic return on capital is higher than the loan interest rate. In a market economy, the interest rate is determined, among other things being equal, by the amount of borrowed capital. The higher the amount of borrowed capital in the structure of the organization’s sources of funds, the higher the interest rate and the lower the net profit of the organization. An organization that has a significant share of borrowed capital is called an organization with a high level of financial leverage, or a financially dependent company; An organization that finances its activities only from its own funds is called a financially independent company.
If the organization does not use loans and borrowings, financial leverage is equal to 1, that is, this factor does not have any impact on the formation of profit, and, therefore, net profit has changed only under the influence of production factors.
If an organization uses loans and borrowings, then the level of financial leverage will increase as these sources grow. The higher the level of financial leverage, the greater its impact on net profit.
An indicator reflecting the level of additionally generated profit on equity capital at different share use of borrowed funds is called the financial leverage effect. It is calculated by the following formula:
EFL = (1 - SNP) x (KVRa - PC) * ZK/SK,
where EFL is the effect of financial leverage, which consists in an increase in the return on equity ratio, %;
SNP - income tax rate, expressed as a decimal fraction;
KVRa - gross return on assets ratio (ratio of gross profit to average asset value), %;
PC - the average size loan interest paid by the organization for the use of borrowed capital, %;
ZK - the average amount of borrowed capital used by the organization;
SK is the average amount of the organization's equity capital.
At the same time, it is necessary to pay attention to the dependence of the effect of financial leverage on the ratio of the return on assets ratio and the level of interest for the use of borrowed capital. If the gross return on assets ratio is greater than the level of interest on the loan, then the effect of financial leverage is positive. If these indicators are equal, the effect of financial leverage is zero. If the level of interest on a loan exceeds the gross return on assets ratio, the effect of financial leverage is negative.
The mechanism of formation of the effect of financial leverage can be expressed graphically.
Drawing. Graph of the formation of the effect of financial leverage
The given formula for calculating the effect of financial leverage allows us to distinguish three main components:
1. Tax adjuster of financial leverage (1-Snp), which shows to what extent the effect of financial leverage is manifested in connection with different levels income taxation.
2. Financial leverage differential (KVRa-PC), which characterizes the difference between the gross return on assets ratio and the average interest rate on a loan.
3. Financial leverage ratio (LC/SC), which characterizes the amount of borrowed capital used by the enterprise per unit of equity capital.
Tax corrector of financial leverage practically does not depend on the activities of the organization, since the profit tax rate is established by law. At the same time, in the process of managing financial leverage, a differential tax adjuster can be used in the following cases:
a) if according to various types activities of the organization, differentiated rates of taxation of profits are established;
b) if the organization uses tax benefits on profits for certain types of activities;
c) if individual subsidiaries of the organization operate in the free economic zones of their country, where a preferential income tax regime applies;
d) if individual subsidiaries of the organization operate in countries with a lower level of profit taxation.
In these cases, by influencing the sectoral or regional structure of production (and, accordingly, the composition of profit according to the level of its taxation), it is possible, by reducing the average rate of profit taxation, to increase the impact of the tax corrector of financial leverage on its effect (all other things being equal).
Financial leverage differential is the main condition that forms the positive effect of financial leverage. This effect manifests itself only if the level of gross profit generated by the organization's assets exceeds the average interest rate for the loan used. The higher the positive value of the financial leverage differential, the higher, other things being equal, its effect.
Due to the high dynamics 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.
First of all, during a period of deterioration in financial market conditions, the cost of borrowed funds may increase sharply, exceeding the level of gross profit generated by the organization's assets.
In addition, a decrease in the financial stability of an organization in the process of increasing the share of borrowed capital used leads to an increase in the risk of its bankruptcy, which forces lenders to increase the interest rate for the loan, taking into account the inclusion of a premium for additional financial risk. At a certain level of this risk (and, accordingly, the level of the general interest rate for the loan), the financial leverage differential can be reduced to zero (at which the use of borrowed capital will not increase the return on equity) and even have a negative value (at which the return on equity will decrease, since part of the net profit generated by equity capital will go to the formation of used borrowed capital at high interest rates).
Finally, during a period of deterioration in commodity market conditions, the volume of product sales decreases, and, accordingly, the size of the organization’s gross profit from production activities decreases. Under these conditions, a negative value of the financial leverage differential can be formed even at constant interest rates for the loan due to a decrease in the gross return on assets ratio.
In light of the above, we can conclude that the formation of a negative value of the financial leverage differential for any of the above reasons always leads to a decrease in the return on equity ratio. In this case, the organization's use of borrowed capital has a negative effect.
Financial leverage ratio is the lever (leverage in literal translation - leverage) that causes a positive or negative effect obtained due to its corresponding differential. At positive value differential, any increase in the financial leverage ratio will cause an even greater increase in the return on equity ratio, and when negative value differential, an increase in the financial leverage ratio will lead to an even greater rate of decline in the return on equity ratio. In other words, an increase in the financial leverage ratio causes an even greater increase in its effect (positive or negative depending on the positive or negative value of the financial leverage differential).
Thus, with a constant differential, the financial leverage ratio is the main generator of both the increase in the amount and level of profit on equity, and the financial risk of losing this profit. Similarly, with a constant financial leverage ratio, positive or negative dynamics of its differential generate both an increase in the amount and level of return on equity and the financial risk of its loss.
Knowledge of the mechanism of influence of financial capital on the level of profitability of equity capital and the level of financial risk allows you to purposefully manage both the cost and capital structure of the organization.
Financial leverage is a factor in the change in net profit, and production leverage is a factor influencing the change in profit before interest and taxes, and, of course, net profit, as a derivative of the total financial result. In practice, of course, it is quite difficult to eliminate the influence of only these noted types of leverage. Therefore, judgments about the effectiveness of managing these factors are made on the basis of changes in profit. In order to at least partially eliminate the cross-influence of both types of leverage, a conditional rule has been adopted, in a certain sense, according to which operating leverage is linked to earnings before interest and taxes, and financial leverage is linked to net profit. The Ufl coefficient has a clear economic meaning. It shows how many times the profit from sales exceeds the profit after interest. The greater the volume of borrowed funds attracted by an enterprise, the greater the amount of interest paid on them, the higher the level of financial leverage.
The effect of financial leverage is that the higher its value, the more non-linear the relationship between net profit and profit from ordinary activities becomes - a slight change (increase or decrease) in profit from sales in conditions of high financial leverage can lead to a significant change in net profit .
An increase in the return on equity when attracting borrowed capital is justified, since the owner of the capital in this case bears an additional risk, called financial. It is associated with a possible lack of funds to pay interest on long-term loans and borrowings. An increase in financial leverage is accompanied by an increase in the degree of riskiness of a given enterprise - the greater the share of borrowed funds in the total capital, the greater the risk of non-receipt Money owners of their own capital.
Spatial comparison of levels of financial leverage is possible only if the basic amount of profit from the sale of the compared enterprises is the same.
A generalized integral indicator for assessing the size of the influence of operational and financial leverage is called operational-financial leverage, however, there is a fairly widespread opinion that they should be inversely related - high level operational leverage in an organization implies the desirability of relatively low level financial leverage, and vice versa. The explanation for this is obvious from the perspective of both total risk and total fixed costs.
Its level is assessed the following indicator:
Ul=Upl*Ufl
Production and financial risks are summarized by the concept of general risk, which is understood as the risk associated with a possible lack of funds to cover current expenses and expenses for servicing external sources of funds.
The economic interpretation of the indicator is as follows - with the current structure, an increase in profit from product sales by y% will lead to an increase in net profit by Ufl * y%, an increase in production volume by x% will lead to an increase in net profit by Ul * x% or Upl * Ufl * x%.
At analysis of financial statements, to determine the level of financial stability in the long term, the financial leverage ratio is used.
The activities of any commercial enterprise are not without financial risk. The risk determined by the structure of capital sources is called financial risk. One of important characteristics financial risk is the ratio between equity and borrowed capital. Attracting additional borrowed funds is beneficial to the enterprise from the point of view of obtaining additional profit, provided that the profitability of total capital exceeds the profitability of borrowed capital. Managing and working in a large enterprise is more profitable and prestigious than in a small one. For a larger total capital, there are wider investment opportunities. But it is necessary to take into account that interest for the use of borrowed capital must be paid in full and on time, unlike dividends. If there is a decrease in sales volume, interruptions in the supply of components or raw materials, personnel problems, etc. The risk of bankruptcy is higher for a company with high loan servicing costs. As a consequence of the increase in financial risk, the price of additionally attracted capital increases.
Financial leverage ratio
Definition. The financial leverage ratio is defined as the ratio of debt capital to equity capital.
Formula icon (acronym): D.R.
Synonyms: leverage, total liabilities to equity, gearing ratio, share of borrowed funds, leverage, or financial leverage, Financial Leveraged, Debt Ratio, Total debt to equity, TD/EQ)
Calculation formula:
DR - financial leverage ratio (Debt Ratio), tenths
CL - current liabilities (Current Liabilities), rub.
LTL - Long Term Liabilities, rub
LC - loan capital, rub
EC - equity capital, rub
Purpose. The financial leverage ratio is directly proportional financial risk enterprise and reflects the share of borrowed funds in the sources of financing the assets of the enterprise.
Refers to capitalization ratios used to control and regulate the structure of sources of funds and characterizes the share of borrowed funds.
Note #1. It is more correct to calculate the indicator “financial leverage ratio” not according to financial statements, but according to the market valuation of assets. Most often, a successfully operating enterprise has a market value of equity capital that exceeds its book value, which means that the value of the financial leverage ratio indicator is lower and the level of financial risk is lower.
Note #2. A high value of the financial leverage ratio can be afforded by firms that have a stable and predictable flow of money for their products. The same applies to enterprises that have a large share of liquid assets (trade and distribution enterprises, banks).
For shareholders, in addition to increasing the risk of bankruptcy, it is important to increase the relative dispersion of income.
Example No. 1. Let's assume that the balance sheet profit of enterprise No. 1 and enterprise No. 2 is estimated at 1 million rubles. The standard deviation of balance sheet profit from the expected is 400 thousand rubles. Enterprise No. 1 has no debts, and No. 2 has a loan from the bank: 2,500 thousand rubles at 16% per annum. For simplicity, we will not take taxes into account.
The income of shareholders of item No. 1 will be 1 million rubles.
The income of shareholders of item No. 2 will be 1000 - 2500 * 0.16 = 600 thousand rubles.
The coefficient of variation for item No. 1 is 400 / 1000 = 0.4
The coefficient of variation for item No. 2 is 400 / 600 = 0.67
The dispersion of the expected income of shareholders is the same, but the volume of income is greater for item No. 1 and, as a result, the relative dispersion for this enterprise is less.
"Leverage" (approximately "lever") is an American term when applied to economics, meaning a certain factor, with a slight change in which the indicators associated with it change greatly. The use of additional (borrowed) capital can be understood as strengthening equity capital in order to obtain greater profits.
The financial leverage ratio reflects the financial risk of the enterprise. For more detailed analysis changes in the value of the financial leverage ratio, and the factors that influenced it, use the 5-factor analysis of the financial leverage ratio.
It is more correct to calculate the indicator “financial leverage ratio” not according to financial statements, but according to the market valuation of assets. Most often, a successfully operating enterprise market price equity capital exceeds the book value, which means that the value of the financial leverage ratio indicator is lower and the level of financial risk is lower.
Example No. 2. For JSC " Siberian forest"it is necessary to raise funds in the amount of 150 million rubles. There are two options for raising funds: 1) issue of ordinary shares; 2) bank loan at 18% per annum. The number of shares already issued is 350 thousand. Balance sheet profit before interest and taxes 175 million rubles. The income tax rate is 36%. The market price of shares is 1,450 rubles. Determine earnings per share (EPS - earning per share) for both options.
Let's determine the number of ordinary shares (for simplicity, we do not take into account the depreciation rate, placement cost, etc.) that need to be put into circulation under the first option: 150,000,000 / 1450 = 103,448 shares.
Let's calculate the amount of interest payments according to the second option: 150 * 0.18 = 27 million rubles.
Profit after tax var. No. 1: 175*(1 - 0.36) = 112 million rubles
Profit after tax var. No. 2: (175-27)*(1 - 0.36) = 94.72 million rubles
Earnings per share var. No. 1: 112,000,000 / (350,000 + 103,448) = 247.0 rubles.
Earnings per share var. No. 2: 94,720,000 / 350,000 = 270.63 rubles.
The second option has higher earnings per share by 270.63/247 = 1.0956 or 9.56%.
Financial leverage effect
To assess the relationship between the financial leverage ratio and return on equity, an indicator such as the financial leverage effect is used.
The effect of financial leverage shows by what percentage the return on equity increases due to the attraction of borrowed funds. The recommended EGF value is 0.33 - 0.5. The effect of financial leverage occurs due to the difference between return on assets and the cost of borrowed funds. For a more detailed analysis of changes in the value of the effect of financial leverage and the factors that influenced it, use the 5-factor analysis of the effect of financial leverage.
Formula for financial leverage effect is output as follows:
let's assume that
ROA EBIT - return on assets calculated through earnings before interest and taxes (EBIT), %;
Let EBIT be earnings before interest and taxes;
NI - net profit;
EC - average annual amount of equity capital;
TRP - income tax rate (Tax Rate Profit), %;
WACLC - weighted average cost of borrowed capital, %;
LC is the average annual amount of borrowed capital.
Then the return on equity will be:
ROE = NI/EC.
Profit before taxes:
EBT = NI + LC * WACLC.
Earnings before interest and taxes:
EBIT = EBT / (1 - TRP/100).
Profitability return on assets calculated through earnings before interest and taxes (EBIT):
ROA EBIT = EBIT / (EC + LC) = (NI + LC * WACLC) / (1 - TRP/100) / (EC + LC);
Hence NI = ROA * (1 - TRP/100) * (EC + LC) - LC * WACLC.
Let's substitute ROE NI into the formula:
ROE = (ROA * (1 - TRP/100) * (EC + LC) - LC * WACLC) / EC;
ROE = (1 - TRP/100) * ROA EBIT + (1 - TRP/100) * (ROA EBIT - WACLC) * LC / EC.
Let us isolate the component with financial leverage from this formula; this is the effect of financial leverage DFL (EFF):
DFL = (ROA EBIT - WACLC) * (1 - TRP/100) * LC / EC.
Example No. 3. Profit before interest and taxes for Luna LLP and Phobos LLP is the same and equal to 23 million rubles. The equity capital of Luna LLP is 18.5 million rubles and that of Phobos LLP is 78 million rubles. Luna LLP has borrowed funds in the amount of 59.5 million rubles, borrowed at 14.4% per annum. Calculate return on equity (ROE) and EGF.
Let's determine return on assets (ROA):
ROA f = 23 / 78 = 0.295 or 29.5%
ROA l = 23 / (18.5 + 59.5) = 0.295
Let's calculate the effect of financial leverage for Luny LLP:
DFL l = (29.5% -14.4%)*(1-0.24)*59.5/18.5 = 36.91%
Interest payable to Luny LLP = 59.5 * 0.144 = 8.568 million rubles.
The effect of financial leverage taking into account the effects of inflation
The effect of financial leverage (DFL) taking into account the effects of inflation (debts and interest on them are not indexed) is calculated using the following formula.
