Any company strives to increase its market share. In the process of formation and development, the company creates and increases its own capital. At the same time, it is very often necessary to attract external capital to boost growth or launch new areas. For a modern economy with a well-developed banking sector and exchange structures, it is not difficult to get access to borrowed capital.
Capital balance theory
When raising borrowed funds, it is important to strike a balance between the commitments made to repay and the goals set. Violating it, you can get a significant slowdown in development and the deterioration of all indicators.
According to the Modigliani-Miller theory, the presence of a certain percentage of debt capital in the structure of the total capital that a company has is beneficial for the current and future development of the company. Borrowed funds at an acceptableservice prices allow them to be directed to promising areas, in this case, the effect of a money multiplier will work when one invested unit gives an increase in an additional unit.
But with a high leverage, the company may not meet its internal and external obligations by increasing 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 a balance in the overall capital structure. This is very important.
Financial leverage (lever), definition
The leverage ratio represents the existing ratio between the two capitals in the company: own and borrowed. For a better understanding, the definition can be formulated differently. The leverage ratio is an indicator of the risk that a company takes on by creating a certain structure of funding sources, that is, using both its own and borrowed funds as them.
For understanding: the word "leverage" is English, meaning "lever" in translation, so often the leverage of financial leverage is called "financial leverage". It is important to understand this and not to think that these words are different.
Components of the "shoulder"
The financial leverage ratio takes into account several components that will influence 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 the company on this issue can regulate the level of tax deductions only by changing the selected tax regimes.
- Indicator of financial leverage. This is the ratio of borrowed funds to equity. Already this indicator can give an initial idea of the price of capital raised.
- Financial leverage differential. Also an indicator of compliance, which is based on the difference between the profitability of assets and the interest paid on loans taken.
Formula of financial leverage
You can calculate the leverage ratio, the formula of which is quite simple, as follows.
Leverage=Debt/Equity
At first glance, everything is clear and simple. The formula shows that the leverage ratio is the ratio of all borrowed funds to equity capital.
Leverage of financial leverage, effects
Leverage (financial) is associated with borrowed funds, which are aimed at the development of the company, and profitability. Having determined the capital structure and obtained the ratio, that is, having calculated the coefficient of financial leverage, the formula for the balance sheet of which is presented, we can evaluate the effectiveness of capital (that is, its profitability).
The leverage effect gives an understanding of how much theefficiency of own capital due to the fact that there was an attraction of external capital into the turnover of the company. To calculate the effect, there is an additional formula that takes into account the indicator calculated above.
Distinguish between positive and negative effects of financial leverage.
First - when the difference between the return on total capital after all taxes have been paid exceeds the interest rate for the loan provided. If the effect is greater than zero, that is, positive, then it is profitable to increase the leverage and you can attract additional borrowed capital.
If the effect has a minus sign, then you should take measures to prevent loss.
American and European interpretations of the leverage effect
Two interpretations of the leverage effect are built on which accents are more taken into account in the calculation. This is a more in-depth look at how the 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 received after the company has completed all tax payments. This model takes into account the tax component.
The European concept is based on the effectiveness of borrowed capital. It examines the effects of the use of equity capital and compares it with the effect of using borrowed capital. In other words, the concept is based on an assessment of the profitability of each type of capital.
Conclusion
Any company strives at least to reach the break-even point, and as a maximum - to obtain high profitability. To achieve all the goals, there is not always enough own capital. A lot of companies resort to attracting borrowed funds for development. It is important to maintain a balance between own capital and attracted. It is to determine how this balance is observed in the current time, and the indicator of financial leverage is used. It helps to determine how much the current capital structure allows you to work with additional borrowed funds.
