For any enterprise, the priority is the rule that both own and borrowed funds must provide a return in the form of profit (income). Action financial leverage(leverage) characterizes the feasibility and effectiveness of the use of borrowed funds by the enterprise as a source of financing economic activity.
The effect of financial leverage is that the company, using borrowed funds, changes the net profitability of own funds. This effect arises from the discrepancy between the profitability of assets (property) and the "price" of borrowed capital, i.e. average bank rate. At the same time, the enterprise must provide for such a return on assets so that the funds are sufficient to pay interest on the loan and pay income tax.
It should be borne in mind that the average calculated interest rate does not coincide with the interest rate accepted under the terms of the loan agreement. The average settlement rate is set according to the formula:
SP \u003d (FIk: amount of AP) X100,
joint venture - the average settlement rate for a loan;
Fick - actual financial costs for all loans received for the billing period (the amount of interest paid);
AP amount – total amount borrowed funds attracted in the billing period.
The general formula for calculating the effect of financial leverage can be expressed as:
EGF \u003d (1 - Ns) X(Ra - SP) X(GK:SK),
EGF - the effect of financial leverage;
Ns – income tax rate in fractions of a unit;
Ra – return on assets;
joint venture - average calculated interest rate for a loan in %;
ZK - borrowed capital;
SC - equity.
The first component of the effect is tax corrector (1 - Hs), shows the extent to which the effect of financial leverage is manifested in connection with different levels of taxation. It does not depend on the activities of the enterprise, since the income tax rate is approved by law.
In the process of managing financial leverage, a differentiated tax corrector can be used in cases where:
on various types activities of the enterprise differentiated tax rates are established;
on certain types activities of the enterprise use income tax benefits;
individual subsidiaries (branches) of the enterprise operate in free economic zones, both in their own country and abroad.
The second component of the effect is differential (Ra - SP), is the main factor that forms the positive value of the effect of financial leverage. Condition: Ra > SP. The higher the positive value of the differential, the more significant, other things being equal, the value of the effect of financial leverage.
Due to the high dynamism of this indicator, it requires systematic monitoring in the management process. The dynamism of the differential is due to a number of factors:
in a period of deterioration in the financial market, the cost of raising borrowed funds may increase sharply and exceed the level of accounting profit generated by the company's assets;
the decrease in financial stability, in the process of intensive attraction of borrowed capital, leads to an increase in the risk of bankruptcy of the enterprise, which makes it necessary to increase interest rates for a loan, taking into account the premium for additional risk. The financial leverage differential can then be reduced to zero or even to a negative value. As a result, profitability equity will decrease, because part of the profit it generates will be used to service the debt received at high interest rates;
during a period of deterioration in the situation on the commodity market, a decrease in sales and the amount of accounting profit negative meaning differential can be formed even at stable interest rates due to lower return on assets.
Thus, the negative value of the differential leads to a decrease in the return on equity, which makes its use inefficient.
The third component of the effect is debt ratio or financial leverage (GK: SK) . It is a multiplier that changes the positive or negative value of the differential. With a positive value of the differential, any increase in the debt ratio will lead to an even greater increase in the return on equity. With a negative value of the differential, the increase in the debt ratio will lead to an even greater drop in the return on equity.
So, with a stable differential, the debt ratio is the main factor affecting the return on equity, i.e. it generates financial risk. Similarly, with the debt ratio unchanged, a positive or negative value of the differential generates both an increase in the amount and level of return on equity, and the financial risk of losing it.
Combining the three components of the effect (tax corrector, differential and debt ratio), we obtain the value of the effect of financial leverage. This method of calculation allows the company to determine the safe amount of borrowed funds, that is, acceptable lending conditions.
To realize these favorable opportunities, it is necessary to establish the relationship and contradiction between the differential and the debt ratio. The fact is that with an increase in the amount of borrowed funds, the financial costs of servicing the debt increase, which, in turn, leads to a decrease in the positive value of the differential (with a constant return on equity).
From the above, the following can be done conclusions:
if new borrowing brings to the enterprise an increase in the level of the effect of financial leverage, then it is beneficial for the enterprise. At the same time, it is necessary to control the state of the differential, since with an increase in the debt ratio, a commercial bank is forced to compensate for the increase in credit risk by increasing the “price” of borrowed funds;
the creditor's risk is expressed by the value of the differential, since the higher the differential, the lower the bank's credit risk. Conversely, if the differential becomes less than zero, then the leverage effect will act to the detriment of the enterprise, that is, there will be a deduction from the return on equity, and investors will not be willing to buy shares of the issuing enterprise with a negative differential.
Thus, an enterprise's debt to a commercial bank is neither good nor evil, but it is its financial risk. By attracting borrowed funds, an enterprise can more successfully fulfill its tasks if it invests them in highly profitable assets or real investment projects with a quick return on investment.
The main task for a financial manager is not to eliminate all risks, but to take reasonable, pre-calculated risks, within the positive value of the differential. This rule is also important for the bank, because a borrower with a negative differential is distrustful.
Financial leverage is a mechanism that a financial manager can master only if he has accurate information about the profitability of the company's assets. Otherwise, it is advisable for him to treat the debt ratio very carefully, weighing the consequences of new borrowings in the loan capital market.
The second way to calculate the effect of financial leverage can be viewed as a percentage (index) change in net profit per ordinary share, and the fluctuation in gross profit caused by this percentage change. In other words, the effect of financial leverage is determined by the following formula:
leverage strength = percentage change in net income per ordinary share: percentage change in gross income per ordinary share.
The smaller the impact of financial leverage, the lower the financial risk associated with this enterprise. If borrowed funds are not involved in circulation, then the force of the financial leverage is equal to 1.
The greater the force of financial leverage, the higher the company's level of financial risk in this case:
for a commercial bank, the risk of non-repayment of the loan and interest on it increases;
for the investor, the risk of reducing dividends on the shares of the issuing enterprise owned by him increases from high level financial risk.
The second method of measuring the effect of financial leverage makes it possible to perform an associated calculation of the strength of the impact of financial leverage and establish the total (general) risk associated with the enterprise.
In terms of inflation if the debt and interest on it are not indexed, the effect of financial leverage increases, since debt servicing and the debt itself are paid for with already depreciated money. It follows that in an inflationary environment, even with a negative value of the differential of financial leverage, the effect of the latter can be positive due to non-indexation of debt obligations, which creates additional income from the use of borrowed funds and increases the amount of equity capital.
Financial lever characterizes the ratio of all assets to equity, and the effect of financial leverage is calculated by multiplying it by the economic profitability indicator, that is, it characterizes the return on equity (the ratio of profit to equity).
The effect of financial leverage is an increment to the return on equity obtained through the use of a loan, despite the payment of the latter.
An enterprise using only its own funds limits their profitability to about two-thirds of economic profitability.
РСС - net profitability of own funds;
ER - economic profitability.
An enterprise using a loan increases or decreases the return on equity, depending on the ratio of own and borrowed funds in liabilities and on the interest rate. Then there is the effect of financial leverage (EFF):
(3)
Consider the mechanism of financial leverage. In the mechanism, a differential and a shoulder of financial leverage are distinguished.
Differential - the difference between the economic return on assets and the average calculated interest rate (AMIR) on borrowed funds.
Due to taxation, unfortunately, only two-thirds of the differential remain (1/3 is the profit tax rate).
Shoulder of financial leverage - characterizes the strength of the impact of financial leverage.
(4)
Let's combine both components of the effect of financial leverage and get:
(5)
(6)
Thus, the first way to calculate the level of financial leverage effect is:
(7)
The loan should lead to an increase in financial leverage. In the absence of such an increase, it is better not to take a loan at all, or at least calculate the maximum amount of credit that leads to growth.
If the loan rate is higher than the level of economic profitability of the tourist enterprise, then increasing the volume of production due to this loan will not lead to the return of the loan, but to the transformation of the enterprise from profitable to unprofitable.
Here we should highlight two important rules:
1. If a new borrowing brings the company an increase in the level of financial leverage, then such borrowing is profitable. But at the same time, it is necessary to monitor the state of the differential: when increasing the leverage of financial leverage, a banker is inclined to compensate for the increase in his risk by increasing the price of his “commodity” - a loan.
2. The creditor's risk is expressed by the value of the differential: the larger the differential, the lower the risk; the smaller the differential, the greater the risk.
You should not increase the financial leverage at any cost, you need to adjust it depending on the differential. The differential must not be negative. And the effect of financial leverage in world practice should be equal to 0.3 - 0.5 of the level of economic return on assets.
Financial leverage allows you to assess the impact of the capital structure of the enterprise on profit. The calculation of this indicator is expedient in terms of assessing the effectiveness of the past and planning the future financial activities enterprises.
The advantage of rational use of financial leverage lies in the possibility of extracting income from the use of capital borrowed at a fixed percentage in investment activities that bring a higher interest than paid. In practice, the value of financial leverage is affected by the scope of the enterprise, legal and credit restrictions, and so on. Too high financial leverage is dangerous for shareholders, as it involves a significant amount of risk.
Commercial risk means uncertainty about a possible result, the uncertainty of this result of activity. Recall that risks are divided into two types: pure and speculative.
Financial risks are speculative risks. An investor, making a venture capital investment, knows in advance that only two types of results are possible for him: income or loss. A feature of financial risk is the likelihood of damage as a result of any operations in the financial, credit and exchange areas, transactions with stock securities, that is, the risk that arises from the nature of these operations. Financial risks include credit risk, interest rate risk, currency risk, risk of lost financial profit.
The concept of financial risk is closely related to the category financial leverage. Financial risk is the risk associated with a possible lack of funds to pay interest on long-term loans and borrowings. The increase in financial leverage is accompanied by an increase in the degree of riskiness of this enterprise. This is manifested in the fact that for two tourist enterprises with the same volume of production, but different level financial leverage, the variation in net profit due to changes in the volume of production will not be the same - it will be greater for an enterprise with a higher level of financial leverage.
The effect of financial leverage can also be interpreted as the change in net income per ordinary share (as a percentage) generated by a given change in the net result of the operation of investments (also as a percentage). This perception of the effect of financial leverage is typical mainly for American school financial management.
Using this formula, they answer the question of how many percent the net profit per ordinary share will change if the net result of the operation of investments (profitability) changes by one percent.
After a series of transformations, you can go to the formula the following kind:
Hence the conclusion: the higher the interest and the lower the profit, the greater the strength of the financial leverage and the higher the financial risk.
When forming a rational structure of sources of funds, one must proceed from the following fact: to find such a ratio between borrowed and own funds, in which the value of the enterprise's share will be the highest. This, in turn, becomes possible with a sufficiently high, but not excessive effect of financial leverage. The level of debt is for the investor a market indicator of the well-being of the enterprise. The extremely high proportion of borrowed funds in liabilities indicates increased risk bankruptcy. If the tourist enterprise prefers to manage with its own funds, then the risk of bankruptcy is limited, but investors, receiving relatively modest dividends, believe that the enterprise does not pursue the goal of maximizing profits, and begin to dump shares, reducing the market value of the enterprise.
There are two important rules:
1. If the net result of the operation of investments per share is small (and at the same time the financial leverage differential is usually negative, the net return on equity and the dividend level are lower), then it is more profitable to increase equity by issuing shares than to take out a loan: attracting borrowed funds funds costs the company more than raising its own funds. However, there may be difficulties in the process of initial public offering.
2. If the net result of exploitation of investments per share is large (and at the same time the financial leverage differential is most often positive, the net return on equity and the dividend level are increased), then it is more profitable to take a loan than to increase own funds: raising borrowed funds costs the enterprise cheaper than raising own funds. Very important: it is necessary to control the strength of the impact of financial and operational leverage in the event of their possible simultaneous increase.
Therefore, you should start by calculating the net return on equity and net earnings per share.
(10)
1. The pace of increasing the turnover of the enterprise. Increased turnover growth rates also require increased financing. This is due to the increase in variable, and often fixed costs, the almost inevitable swelling of receivables, as well as many other very different reasons, including cost inflation. Therefore, on a steep rise in turnover, firms tend to rely not on internal, but on external financing, with an emphasis on increasing the share of borrowed funds in it, since share issue costs, initial public offering costs and subsequent dividend payments most often exceed the value of debt instruments;
2. Stability of turnover dynamics. An enterprise with a stable turnover can afford a relatively larger share of borrowed funds in liabilities and more fixed costs;
3. Level and dynamics of profitability. It is noted that the most profitable enterprises have a relatively low share of debt financing on average over a long period. The enterprise generates sufficient profits to finance development and pay dividends, and costs more and more more own funds;
4. Structure of assets. If the company has significant assets general purpose, which by their very nature are capable of serving as collateral for loans, then an increase in the share of borrowed funds in the liability structure is quite logical;
5. The severity of taxation. The higher the income tax, the less tax incentives and opportunities to use accelerated depreciation, the more attractive debt financing for the enterprise due to attributing at least part of the interest for the loan to the cost;
6. Attitude of creditors to the enterprise. The play of supply and demand in the money and financial markets determines the average terms of credit financing. But specific conditions the provision of this loan may deviate from the average depending on the financial and economic situation of the enterprise. Whether bankers compete for the right to provide a loan to an enterprise, or money has to be begged from creditors - that is the question. The real possibilities of the enterprise to form the desired structure of funds largely depend on the answer to it;
8. Acceptable degree of risk for the leaders of the enterprise. The people at the helm may be more or less conservative in terms of risk tolerance when making financial decisions;
9. Strategic target financial settings of the enterprise in the context of its actually achieved financial and economic position;
10. The state of the market for short- and long-term capital. With an unfavorable situation in the money and capital market, it is often necessary to simply obey the circumstances, postponing until better times the formation of a rational structure of sources of funds;
11. Financial flexibility of the enterprise.
Example.
Determination of the value of the financial leverage of the economic activity of the enterprise on the example of the hotel "Rus". Let us determine the expediency of the size of the attracted credit. The structure of enterprise funds is presented in Table 1.
Table 1
Structure financial resources enterprises of the hotel "Rus"
| Index | Value |
| Initial values | |
| Hotel asset minus credit debt, mln. rub. | 100,00 |
| Borrowed funds, million rubles | 40,00 |
| Own funds, million rubles | 60,00 |
| Net result of investment exploitation, mln. rub. | 9,80 |
| Debt servicing costs, million rubles | 3,50 |
| Estimated values | |
| Economic profitability of own funds, % | 9,80 |
| Average calculated interest rate, % | 8,75 |
| Financial leverage differential excluding income tax, % | 1,05 |
| Financial leverage differential including income tax, % | 0,7 |
| Financial Leverage | 0,67 |
| Effect of financial leverage, % | 0,47 |
Based on these data, it is possible to following output: Hotel Rus can take out loans, but the differential is close to zero. Minor changes in the production process or increase interest rates can "reverse" the leverage effect. There may come a time when the differential becomes less than zero. Then the effect of financial leverage will act to the detriment of the hotel.
To calculate the effect of financial leverage (EFF), it is necessary to calculate the economic profitability (ER) and the average calculated interest rate (AMIR).
EGF \u003d 2/3 (ER - SRSP) * ZS / SS
Where ER = Net operating result of the investment / (Own funds + Borrowed funds),
IFCI = Finance Cost of Interest / Borrowings * 100%
This formula can be presented in a more extended version.
Service assignment. With the help of an online calculator, a step-by-step analysis of the enterprise's activities is carried out:
- Calculation of the effect of financial leverage.
- Profit sensitivity analysis to changes in the analyzed factor.
- Determination of a compensating change in the volume of sales when the analyzed factor changes.
Instruction. Complete the table, click Next. The decision report will be saved in MS Word format.
Indicators such as Own funds (SS), Borrowed funds (SL), Retained earnings of previous years, Authorized capital, Current Assets, Current Liabilities and Profitability of sales can be determined from the balance sheet data (found through the calculator).
Classification of the effect of financial leverage
Example. Table 1 - Initial data
| Indicators | Meaning |
| 1. Sales proceeds thousand rubles. | 12231.8 |
| 2. Variable costs thousand rubles. | 10970.5 |
| 3. Fixed costs thousand rubles. | 687.6 |
| 4. Own funds (SS) thousand rubles. | 1130.4 |
| 5. Borrowed funds (LL) thousand rubles. | 180 |
| 6. Financial costs for borrowed funds (FI) thousand rubles. | 32.4 |
Determine the financial performance of the enterprise
Table 1 - Performance indicators of the enterprise
1. Calculation of the effect of financial leverage
To calculate the effect of financial leverage (EFF), it is necessary to calculate the economic profitability (ER) and the average calculated interest rate (AMIR).
ER = NREI / Assets * 100 = 606.1 / (1130.4 + 180) * 100 = 46.25%
SRSP \u003d FI / GC * 100 \u003d 32.4 / 180 * 100 \u003d 18%
EGF \u003d 2 / 3 (ER - SRSP) * GL / SS \u003d 2 / 3 (46.25% - 18%) * 180 / 1130.4 \u003d 3.0%
PCC = 2/3 * ER + EGF = 2/3 * 46.25 + 3.0 = 33.84%
The essence of the effect of financial leverage: the effect of financial leverage shows the increment to the return on equity obtained as a result of the use of borrowed capital. In our case, it was 3.0%.
The effect of financial leverage can also be used to assess the creditworthiness of an enterprise.
Since the financial leverage is less than 1 (0.159), this enterprise can be regarded as solvent. The meaning of the effect of financial leverage: the company can apply for additional credit.
Using the graphical method, we determine the safe amount of borrowed funds. Typical differential curves are shown in Figure 1.
Rice. 1. Differential curves
Determine the position of our enterprise on the graph.
ER / SRSP = 46.25 / 18 = 2.57
Where ER \u003d 2.57 SRSP
With additional borrowing, it is necessary that the enterprise does not fall below the main curve (the enterprise is between ER \u003d 3 SRSP and ER \u003d 2 SRSP). Therefore, at the level of tax neutralization at the EGF/RCC point = 1/3, the allowable leverage of the CA/CC financial leverage is 1.0.
Thus, the loan can be increased by 950.4 thousand rubles. and reach 1130.4 thousand rubles.
Let us determine the upper limit of the price of borrowed capital.
ER = 2SRSP
Where SRSP = 46.25% / 2 = 23.13%
CPCP = FI / AP
Where FI \u003d SRSP * GS \u003d 23.13% * 1130.4 \u003d 261.422 thousand rubles.
In this way, this enterprise, without losing financial stability, you can take an additional amount of borrowed funds for 950.4 thousand rubles. Additional borrowing will cost the company 219.795 thousand rubles, if the average interest rate on the loan does not exceed 23.13%.
Calculate critical value net result of exploitation of investments, i.e. such a value at which the effect of financial leverage is equal to zero, and therefore, the return on equity is the same for options, both with the involvement of borrowed funds, and with the use of only own funds.
NREI critical = 1310.4 * 18 = 235.872 thousand rubles.
In our case, the threshold value has been passed, and this indicates that it is profitable for the enterprise to attract borrowed funds.
When comparing 2 enterprises with the same level of economic profitability (Profit from sales / all Assets), the difference in m / d between them may be that one of them does not have loans, while the other actively attracts borrowed funds (NP / SK). That. the difference lies in the different level of return on equity, obtained through a different structure of financial sources. The difference m / d two levels of profitability is the level of the effect of financial leverage. EGF there is an increment to the net profitability of own funds, obtained as a result of the use of the loan, despite its payment.
EFR \u003d (1-T) * (ER - St%) * ZK / SK, where T is the income tax rate (in shares), ER-ek. profitability (%), St% - the average interest rate on the loan,
ER = Sales Profit/All Assets. ER characterizes investment attractiveness enterprises. Har-et efficient use of all capital, despite the fact that you still need to pay% for the loan.
The first component of the EGF is called differential and characterizes the difference between the economic return on assets and the average calculated interest rate on borrowed funds (ER - SIRT).
The second component - the leverage of the financial leverage (financial activity ratio) - reflects the ratio between borrowed and own funds (LC / SK). The more he is, the more financial risks.
The effect of financial leverage allows:
Justify financial risks and evaluate financial risks.
Rules arising from the EGF formula:
If the new borrowing brings an increase in the level of EGF, then it is beneficial for the organization. It is recommended to carefully monitor the state of the differential: when increasing the leverage of financial leverage, the bank tends to compensate for the increase in its own risk by increasing the price of the loan
The larger the differential (d), the lower the risk (respectively, the smaller d, the greater the risk). In this case, the creditor's risk is expressed by the value of the differential. If d>0, you can borrow if d<0, то высокие риск - не рекомендуется занимать, эффект от использования ЗК меньше суммы % за кредит; если d=0, то весь эффект от использования ЗК пойдет на уплату % за кредит.
EGF is an important concept that, under certain conditions, allows you to assess the impact of debt on the profitability of the organization. Financial leverage is typical for situations where the structure of sources of capital formation contains obligations with a fixed interest rate. In this case, an effect similar to the use of operating leverage is created, that is, profit after interest rises / falls at a faster rate than changes in output.
Finnish advantage. lever: capital borrowed by an organization at a fixed interest rate can be used in the course of business in such a way that it will bring a higher profit than the interest paid. The difference accumulates as the profit of the organization.
The effect of operating leverage affects the result before finance costs and taxes. An EGF occurs when an organization is indebted or has a source of funding that entails the payment of fixed amounts. It affects net income and thus the return on equity. EGF increases the impact of annual turnover on the return on equity.
Total leverage effect = Operating leverage effect * Financial leverage effect.
With a high value of both levers, any small increase in the annual turnover of an organization will significantly affect the value of its return on equity.
The effect of operating leverage is the presence of a relationship between the change in sales proceeds and the change in profit. The strength of operating leverage is calculated as the quotient of sales revenue after recovering variable costs to earnings. Operating leverage generates entrepreneurial risk.
The ability to generate income is the main characteristic of the company's capital. In whatever sector of the economy (real or financial) capital is directed as an economic resource, if used effectively, it should always generate income.
Thus, the main goal of any investor is to maximize the return on his invested capital. The capital structure is quite important. The reason for this importance lies in the differences between equity and accounts payable. Equity capital is the main risk capital of the company. The peculiarity of equity capital is that it does not give a guaranteed profit, which must be paid in any course of business.
In addition, there is no fixed timetable for recoupment of long-term investments. The main indicator of return on equity is the return on equity (ROE).
Own vs. borrowed
Any capital that can be withdrawn at the request of the depositor should not be considered as own, but as a debt.
Both short-term and long-term debt must be paid. The longer the term of the loan and the less burdensome the terms of its repayment, the easier it is for the company to service it.
It follows that the greater the share of borrowed funds in the total capital structure, the greater the amount of payments with fixed terms and payment obligations.
And the greater the likelihood of a chain of events leading to an inability to pay interest and principal when due.
Scheme. Interpretations of the concept of "loan capital"
Debt is a less expensive source of cash compared to equity because, unlike dividends, which are distributions of profits, interest is treated as an expense and is therefore tax deductible.
Risk Lever
Among the main characteristics of financial leverage are the following.
1. A large share of borrowed capital in the total amount of long-term sources of financing is characterized as a high level of financial leverage and financial risk.
2. Financial leverage indicates the presence and degree of dependence of the company on third-party investors temporarily lending to the company.
3. Attracting long-term credits and loans is accompanied by an increase in financial leverage and, accordingly, financial risk. This risk is expressed in an increase in the probability of default on debt service obligations. The essence of financial risk is that debt service payments are mandatory. Therefore, in case of insufficient gross profit to cover them, it may be necessary to liquidate part of the assets, which is accompanied by direct and indirect losses.
Based on the return on equity formula (ROE = return on sales x asset turnover ratio x financial leverage), we see that the profitability of a company, in addition to operating results, also depends on the structure of its capital, that is, the sources of financing for its activities.
The sources that ensure the long-term activity of the company consist of long-term liabilities (loans, debt obligations, bonds) and the company's equity capital (preferred and ordinary shares).
Interpreting Capital
One of the objective factors affecting the return on equity is financial leverage.
Financial leverage means the inclusion of debt (borrowed funds) in the capital structure of the company, which gives a constant profit, allows you to get additional profit from equity capital.
Financial leverage is the ratio of borrowed funds to equity.
When determining the financial leverage in practice, the main question arises: what should be classified as "loan capital"?
Borrowed capital has, as a rule, three interpretations.
When determining the financial leverage and the effect of its use, they mean the second option, that is, the entire debt on which interest is paid on its service.
Efficient financing
Strengthening financial leverage, that is, an increase in the share of borrowed funds, is not only a factor that increases the return on equity, but also a factor that increases the risk of insolvency of the company.
For a company with a high level of financial leverage, even a slight change in earnings before interest and taxes (operating income) can lead to a significant change in net income.
The amount of additionally generated profit in terms of equity capital with varying degrees of use of borrowed funds is estimated using such an indicator as the effect of financial leverage (EFF).
The leverage effect formula is as follows:
EFR \u003d (1 - T) x (RA - P) x PFR, where T is the income tax rate, RA is the return on assets on operating profit, P is interest on debt service, PFR is the financial leverage. The financial leverage differential (RFI) is the difference between the return on assets (RA) on operating income and the debt service rate (interest on a loan) (P):
DFR \u003d RA - P
The leverage of financial leverage (PFR) is the ratio of equity capital (SK) and borrowed capital (LC): PFR = LC/SK
Leverage in action
Let's consider the effect of financial leverage on an example.
Example 1
Let's take two companies with the same results of operations, but company A's employed capital consists entirely of equity, while company B has both equity and borrowed capital.
We group the data of the example in table 1.
As can be seen from the table, the effect of financial leverage for company B was:
EGF \u003d (1-0.2) x (16-12) x 200,000/300,000 \u003d 2.1%.
From the example and formula of the effect of financial leverage, it can be seen that the higher the share of borrowed funds in the total amount of capital used, the more profit the company receives from its capital.
Let's consider how different components of the formula for the effect of financial leverage affect the change in its size.
Income tax is established by law, and the organization cannot influence it in any way, however, if the company is diversified, territorially dispersed, it must be taken into account that different types of income tax rates to the budgets of the constituent entities of the Russian Federation may be established for different types of activities in the regions.
A company can, by influencing its regional or production structure, influence the composition of profits by the level of its taxation.
Table 1. Effect of financial leverage
|
No. p / p |
Indicators |
Performance results |
|
|
Company A |
Company B |
||
|
Income tax rate, % | |||
|
Net profit, thousand rubles | |||
|
Increase in return on equity, % | |||
This means that it is possible, by lowering the average profit tax rate, to increase the impact of the tax rate on the effect of financial leverage.
Example 2
According to the results of 2009 and 2010, company B showed the same financial results.
The only difference is that in 2010 the company had two separate subdivisions registered in regions with a reduced income tax rate to the budget of a subject of the Russian Federation, as a result of which the average percentage of income tax for 2010 for the company as a whole was 19%.
Table 2. Influence of the income tax rate on the increase in return on equity
|
No. p / p |
Indicators |
Performance results |
|
|
2010 |
2009 |
||
|
The amount of used capital of the company, thousand rubles. including: | |||
|
The amount of equity, thousand rubles. | |||
|
The amount of borrowed capital, thousand rubles. | |||
|
Operating income excluding taxes and interest on debt service (EBIT), thousand rubles | |||
|
Return on assets based on operating profit, % | |||
|
Interest on a loan for the reporting period, % | |||
|
The amount of interest on debt service, thousand rubles. ((clause 3 x clause 6)/100) | |||
|
Profit including interest on debt service (profit before taxes), thousand rubles (EBT) (p. 4 - p. 7) | |||
|
Income tax rate, % | |||
|
The amount of income tax, thousand rubles. ((clause 8 x clause 9)/100) | |||
|
Net profit, thousand rubles | |||
|
Return on equity based on net profit, % ((clause 11/ clause 2) х 100) | |||
As can be seen from Table 2, a 1 percentage point change in the income tax rate gave company B an increase in the return on equity in 2010 by 0.2 percentage points.
The financial leverage differential is the main condition that forms the positive effect of financial leverage.
The higher the positive value of the differential, the higher, other things being equal, the effect of financial leverage will be.
But this effect will manifest itself only if the gross return on assets is higher than the level of interest on debt service.
If these indicators are equal, the effect will be equal to zero.
If the level of interest on debt service exceeds the gross margin, then the effect of financial leverage will be negative.
Example 3
Consider three companies with a constant debt service rate of 12% and different operating income return on assets.
With a positive value of the differential, any increase in the financial leverage ratio will cause an even greater increase in the return on equity ratio.
And with a negative value of the differential, the increase in the financial leverage ratio will lead to an even greater rate of decline in the return on equity ratio.
Thus, with the differential unchanged, the financial leverage ratio is the main generator of both the increase in the amount and level of return on equity, and the financial risk of losing this profit.
Table 3. Effect of financial leverage differential on the effect of financial leverage
|
No. p / p |
Indicators |
Company 1 |
Company 2 |
Company 3 |
|
Return on assets based on operating income | ||||
|
Debt service interest | ||||
|
Financial leverage differential | ||||
|
Income tax rate | ||||
|
The amount of equity, thousand rubles. | ||||
|
The amount of borrowed capital, thousand rubles. | ||||
|
Financial Leverage | ||||
|
The effect of financial leverage |
Similarly, with a constant financial leverage ratio, the positive or negative dynamics of its differential generates both an increase in the amount and level of return on equity, and the financial risk of its loss.
In the process of financial management, the indicator of the financial leverage differential requires constant monitoring, as it is subject to high volatility. The following factors influence the variability of this indicator.
1. Due to the volatile situation in the financial markets, the cost of borrowings may increase significantly, exceeding the level of gross profit generated by the company's assets.
With an increase in the rate for attracting credit funds, a situation may arise when, under tax legislation, a company will not be able to include the entire debt service rate in expenses.
If such a situation arises, the calculation must take into account the rate that the company can take into account when taxing.
2. An increase in the share of borrowed capital used leads to a decrease in the financial stability of the company and an increase in the risk of bankruptcy, which negatively affects the cost of attracted financial resources, as creditors seek to increase interest by including a premium for additional financial risk in them.
At a certain level of the rate for the use of credit funds, the financial leverage differential can be reduced to zero (in this case, 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).
3. During a period of decrease in sales volumes in the company or due to an increase in the cost of goods sold, the amount of gross profit decreases.
Under such conditions, a negative value of the financial leverage differential can also form at constant interest rates for a loan due to a decrease in the gross return on assets.
The formation of a negative value of the financial leverage differential for any of the considered reasons always leads to a decrease in the return on equity ratio.
In this case, the use of borrowed funds has a negative effect.
Managing the level of financial leverage does not mean achieving a certain target value, but controlling its dynamics and providing a comfortable safety margin in terms of operating profit (earnings before interest and taxes) exceeding the amount of conditionally fixed financial expenses.
