What does the effect of financial leverage show?
Suppose that there are two enterprises with a similar level of economic profitability and the same value of assets. However, as sources of financing of the first enterprise, only own funds are used, and of the second - own and borrowed funds.
There is a situation in which, with the same economic profitability, due to differences in the structure of financing, different values of return on equity (RCC) are obtained. This difference in these performance indicators of the two organizations is called the “financial leverage effect”.
How do funding sources affect profitability?
The effect of financial leverage (EGF) is an increase in the value of return on equity that arises from the use of loans, despite their payment. From here follows two conclusions:
1) An enterprise that uses only its own funds in its activities,without resorting to the services of credit institutions, keeps their profitability within the limits of the RCC value = (1-T) * ER, where T is the value of the interest rate on income tax.
2) An enterprise that uses the funds received in a loan to carry out its activities changes the RCC - it increases or decreases depending on the size of the interest rate and the ratio of borrowed and own funds. In such situations, there is such a phenomenon as the effect of financial leverage.
RSS = (1-T) * ER + EGF
To determine the EGF value, it is necessary to find the value of the indicator, called the average interest rate (SRSP). This indicator is calculated as the ratio of the existing financial costs of credit funds to the total amount of funds taken on credit by the enterprise.
Elements of the financial leverage effect
The effect of financial leverage is formed by two components:
1. Differential: (1-T) * (ER-SRSP).
2. The shoulder of financial leverage, which is located as the ratio of borrowed funds to own.
The formula for calculating the EGF is determined by the product of these two components.
1.The effect of financial leverage shows whether a loan is profitable for the enterprise. A positive value of the EFR indicator means that raising borrowed funds will be beneficial for the organization and expedient.
2. Attracting additional credit increases the value of the financial leverage index, respectively, and the risk of non-repayment of borrowed funds increases. This is offset by an increase in the interest rate on loans. Consequently, the average interest rate also increases.
3. The effect of financial leverage determines whether an enterprise has the ability in an emergency to attract additional credit funds. To do this, you must follow the value of one of its components - the differential. The differential must be positive, and some margin of safety should be maintained for this indicator.