The leverage of financial leverage is applied both at the enterprise, for calculating the necessary loan amount for securing assets, and in exchange trading. This tool helps to increase profits by attracting external sources of funds. However, its inept use can lead to a deterioration in the economic situation and even cause bankruptcy.
What is financial leverage
Leverage of financial leverage is the ratio of own assets in relation to borrowed funds. In fact, it expresses the ability of an enterprise to pay a debt on time and in full. Banks and other credit organizations are required to calculate this parameter in order to determine the maximum loan amount that they can give the company. This definition is true both for enterprises and for individual investors using this tool during speculative operations. Usually it is expressed as a share or percentage of funds received in debt or temporary use. For enterprises and banks, some formulas for calculating financial leverage are used, for investors - others. When using this tool, it is important to evaluate not only the benefits of the application, but also the risk that it carries.
Destination
Financial leverage is needed in order to increase the amount of working capital. Entrepreneurs resort to this financial instrument in order to expand economic activity. Other financial problems associated with the activities of the enterprise can also be solved with the help of a loan.
The calculation of the leverage of financial leverage is performed by both banks and individual businessmen. It is necessary in order to correctly assess the possible risks associated with the use of leverage, as well as to determine the amount that the company or investor can count on.
Calculation formula
To calculate the leverage of financial leverage, the formula is as follows:
DPF = ((1-T) * (POA - p) * D) / E,
where DFL stands for the effect of financial leverage;
T is the interest rate of the income tax adopted in the country;
ROA - return on assets of the enterprise;
p - interest rate on the loan;
D - the amount of funds taken on credit;
E - equity.
However, among managers and accountants, another formula was used to calculate the leverage of financial leverage. The data for the calculations are taken from the financial statements. It has the following form:
DFL = ROE - ROA,
where POE is the return on equity. This parameter is calculated by the formula:
ROE = Net Profit / Total for Section 3.
The return on assets of the enterprise is calculated by the formula:
ROA = Net Profit / Total Balance.
This method is convenient in that all calculations can be automated. Moreover, only the effect of using the leverage of financial leverage can be estimated in this way, and not the amount needed to expand or maintain the stable operation of the enterprise can be calculated. This formula is not used to analyze past and current activities, but for forecasting.
Calculation Example
To make the above formulas clearer, the following are the calculations performed for the company Snezhka based on the data of its annual report.
POE = - 21055/480171 = - 0.044;
POA = -21055 / 1488480 = - 0.014;
DFL = - 0.044 + 0.014 = - 0.03;
How to interpret the information received? What does the result mean? If in calculating the ratio of borrowed and own funds came out less than 0.8, then the state of the enterprise is considered not quite stable. An entity does not have enough current assets that it can realize to repay short-term loans. If it is more than 0.8 or equal to it, then the risk is insignificant and the company is not in danger, since it will be able to timely sell its assets and make a payment if necessary.
As can be seen from the calculations, OJSC Snezhka is not only unable to pay off current debts, but it also has no right to rely on a new loan from the bank to expand its activities. Here, at least pay off arising debts. This situation has been observed at many Russian enterprises, especially over the past 2-3 years. However, for the bank this is not a reason to take risks again. To determine whether financial leverage will help rectify the situation, calculations need to be carried out not in one year, but in 3-5 years of operation of the enterprise.
What do the data obtained during the calculations mean?
The ratio of borrowed and own funds. But calculations are only half the battle. The information obtained must still be able to analyze. The degree of risk depends on how true the analysis and the decision will be. For the bank - the return of loans, for the businessman - the stable operation of the enterprise and the likelihood of bankruptcy.
As can be seen from the above example, the company has serious problems. In the current period, it received a net loss. An organization may take a loan from a bank to cover any arrears arising from a loss. But this threatens with a loss of stability and a risk of delay in payments on loans, which, in turn, will lead to the appearance of unforeseen expenses in the form of payment of interest and fines.
If the entrepreneur knows in advance the amount of the loan, which he can count on, he can better plan where and what he can spend these funds on. This is precisely the benefit of such calculations.
Use of financial leverage on the stock and currency exchange
The leverage of financial leverage has gained the most widespread use in trading operations on the stock and currency exchanges. By attracting borrowed funds, the investor can acquire more, and therefore, receive higher profits. But the use of leverage in such risky operations often leads to large losses in a short time.
When calculating leverage for investors conducting speculative operations on the exchange, the formula is not used. In this case, leverage is the ratio between the amount of capital and the loan provided for temporary use. The ratio can be as follows: 1:10, 1:50, etc. The larger the ratio, the higher the risk. The deposit amount is multiplied by the size of the leverage. Since fluctuations on the exchange usually amount to only a few percent, leverage allows you to increase the amount of money used by tens and hundreds of times, which makes a profit (loss) significant.