The coefficient of financial leverage (financial leverage)

Any company seeks to increase its market share. In the process of formation and development, the firm creates and increases its own capital. At the same time, it is often necessary to attract external capital for a jump in growth or launch of new directions. For a modern economy with a well-developed banking sector and exchange structures, access to borrowed capital is not difficult.

Theory of the balance of capital

When borrowing funds, it is important to keep a balance between the obligations taken on payment and the goals set. Breaking it, you can get a significant decline in the pace of development and deterioration of all indicators.

According to Modigliani-Miller theory, the presence of a certain percentage of borrowed capital in the structure of the total capital that the company has at its disposal is beneficial for the current and future development of the firm. Borrowed funds at an acceptable price of service allow them to be directed to perspective directions, in this case the effect of the money multiplier will work, when one nested unit will give an increment of an additional unit.

But if there is a high share of borrowed funds, the company may not fulfill its internal and external obligations by increasing the amount of loan servicing.

Thus, the main task of the company, attracting outside capital, to calculate the optimal coefficient of financial leverage and create a balance in the overall structure of capital. It is very important.

Financial leverage (lever), definition

The coefficient of financial leverage is the existing ratio between the two capitals in the company: own and attracted. For a better understanding, it is possible to formulate a definition in a different way. The financial leverage ratio is an indicator of risk that a company takes upon itself, creating a certain structure of sources of financing, that is, using both own and borrowed funds.

For understanding: the word "leverage" is English-speaking, meaning "lever" in translation, so often the leverage of the financial lever is called "financial leverage". It is important to understand this and not to think that these words are different.

Components of the "shoulder"

The ratio of the financial lever takes into account several components that will influence its indicator and effects. Among them are:

1. Taxes, namely, the tax burden that the firm 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.
2. Financial leverage indicator. This is the ratio of borrowed funds to own. Already this indicator can give an initial idea of the price of the attracted capital.
3. The differential of financial leverage. Also, the compliance indicator, which is based on the difference in the profitability of assets and interest that are paid for borrowed loans.

Formula of financial leverage

Calculate the coefficient of financial leverage, the formula of which is fairly simple, can be as follows.

Lever arm = Size of borrowed capital / Own capital amount

At first glance, everything is clear and simple. It can be seen from the formula that the leverage ratio is the ratio of all borrowed funds to own capital.

Leverage 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 having received the ratio, that is, having calculated the coefficient of the financial lever, the formula for the balance of which is presented, it is possible to estimate the efficiency of capital (that is, its profitability).

The effect of the shoulder gives an understanding of how much the effectiveness of equity will change due to the fact that there has been attraction of external capital into the turnover of the firm. To calculate the effect, there is an additional formula that takes into account the calculated index.

There are positive and negative effects of financial leverage.

First, when the difference between the return on total capital after all taxes paid is higher than the interest rate for the loan granted. If the effect is greater than zero, then there is a positive, then increasing the leverage is beneficial and it is possible to 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 effect of leverage

Two interpretations of the effect of the lever are based on what accents are more accounted for in the calculation. This is a more in-depth consideration of how the ratio of financial leverage shows the magnitude of the impact on the company's financial results.

An American model or concept considers a financial lever through the net profit and the profit earned after the company has completed all tax payments. In this model, the tax component is taken into account.

The European concept is based on the effectiveness of leveraging borrowed capital. It looks at the effects of using equity and compares it with the effect of leveraging borrowed capital. In other words, the concept is based on an assessment of the profitability of each type of capital.

Conclusion

Any firm aspires at least to reach the breakeven point, and as a maximum - to obtain high profitability indicators. To implement all the goals set, not always enough equity. Very many firms resort to borrowing for development. It is important to strike a balance between own capital and attracted. It is to determine how far this balance is being maintained in the current time and the financial leverage is applied. It helps to determine how current the structure of capital allows to work with additional borrowed funds.