Any company seeks to increase its market share. In the process of formation and development, the company creates and builds up its own capital. At the same time, it is often necessary to attract external capital to jump in growth or launch new directions. For a modern economy with a well-developed banking sector and exchange structures, access to borrowed capital is not difficult.
Capital balance theory
When attracting borrowed funds, it is important to strike a balance between the commitments to pay and the goals set. Violating it, you can get a significant decrease in the pace of development and the deterioration of all indicators.
According to the Modigliani-Miller theory, the presence of a certain percentage of borrowed capital in the structure of the total capital held by a company is beneficial for the current and future development of the company. Borrowed funds at an affordable service price allow you to direct them to promising areas, in this case the money multiplier effect will work when one invested unit gives an increase in an additional unit.
But in the presence of a high share of borrowed funds, the company may not fulfill its internal and external obligations due to an increase in the amount of loan servicing.
Thus, the main task of a company that attracts third-party capital is to calculate the optimal financial leverage ratio and create an equilibrium in the overall capital structure. It is very important.
Financial leverage (leverage), definition
The financial leverage ratio is the ratio between the two capitals in the company: equity and borrowed. For a better understanding, it is possible to formulate a definition in a different way. The financial leverage ratio is an indicator of the risk that the company assumes, creating a certain structure of financing sources, that is, using both its own and borrowed funds.
For understanding: the word “leverage” is English-speaking, meaning “leverage” in translation, therefore, often the shoulder of financial leverage is called “financial leverage”. It is important to understand this and not to think that these words are different.
Shoulder Components
The financial leverage ratio takes into account several components that will affect its indicator and effects. Among them are:
- Taxes, namely the tax burden that the company bears in carrying out its activities. Tax rates are set by the state, so a company on this issue can regulate the level of tax deductions only by changing the selected tax regimes.
- The indicator of financial leverage. This is the ratio of borrowed funds to own. Already this indicator can give an initial idea of the price of capital raised.
- Differential of financial leverage. Also, the compliance indicator, which is based on the difference in the profitability of assets and interest paid on loans.
Leverage Formula
The financial leverage ratio, the formula of which is quite simple, can be calculated as follows.
Leverage = Amount of borrowed capital / Amount of equity
At first glance, everything is clear and simple. The formula shows that the leverage ratio of financial leverage is the ratio of all borrowed funds to equity.
Leverage financial leverage effects
Leverage (financial) is associated with borrowed funds that are aimed at developing the company, and profitability. Having determined the capital structure and obtained the ratio, that is, by calculating the financial leverage ratio, the formula for the balance of which is presented, we can evaluate the effectiveness of capital (that is, its profitability).
The leverage effect gives an understanding of how much the effectiveness of equity will change due to the fact that external capital was attracted to the company's turnover. To calculate the effect, there is an additional formula that takes into account the indicator calculated above.
Distinguish between the positive and negative effects of financial leverage.
The first is when the difference between the profitability of total capital after all taxes have been paid exceeds the interest rate for the loan. If the effect is greater than zero, that is, positive, then increasing the leverage is beneficial and you can attract additional borrowed capital.
If the effect has a minus sign, then measures should be taken to prevent loss.
American and European interpretations of the leverage effect
Two interpretations of the leverage effect are based on which accents are more taken into account in the calculation. This is a more in-depth consideration of how the financial leverage ratio shows the magnitude of the impact on the company's financial results.
The American model or concept considers financial leverage through net profit and profit obtained after the company has paid all tax payments. This model takes into account the tax component.
The European concept is based on the effectiveness of leveraging capital. It examines the effects of using equity and compares it with the effect of leveraging borrowed capital. In other words, the concept is based on evaluating the profitability of each type of capital.
Conclusion
Any company seeks at least to achieve a breakeven point, and as a maximum - to obtain high rates of profitability. To achieve all of the goals set, equity is not always enough. Too many companies resort to borrowing funds for development. It is important to maintain a balance between equity and borrowed. It is to determine how much this balance is being maintained in the current time, and the financial leverage indicator is used. It helps determine how the current capital structure allows you to work with additional borrowed funds.