Financial leverage, or, as it is also called, financial leverage is a certain ratio of borrowed capital to the company's own financial resources. This indicator allows you to assess the degree of stability and risk of the company. The less its value, the more stable the company feels in the current market conditions. However, the ability to take a loan means for any company the solution of the problems that arise and the receipt of additional profit, that is, an increase in profitability.
The name of this term came to us from the English language, the word "leverage" can be translated as a lever or a means of achieving a result. This is a factor, its slight fluctuation has a significant impact on the indicators that are associated with it.
Attracting borrowed capital is always associated with a certain share of risk. Why do enterprises go for it, because you can completely do it by your own means? The fact is that financial leverage allows you to get additional profit, provided that the return on total capital is greater than the profitability of the borrowed. The more capital that is available to top managers of the company, the wider the range of investment opportunities. However, it is always worth remembering that, unlike dividends, payments for the use of borrowed funds must be made in a timely manner and in full.
The financial leverage ratio is calculated by the following formula:
CFL = NC / SC, where
NZ - net borrowing;
SS - own funds.
Net borrowing is the aggregate amount of bank loans and overdrafts, net of cash and other liquid assets.
Equity is the value of the issued and paid up share capital calculated at the nominal price of the share, plus retained earnings and other accumulated reserves, together with additional capital, if any, for this enterprise.
The coefficient that determines financial leverage is often calculated using a 5-factor model:
CFL = (borrowed capital / amount of assets): (fixed capital / amount of assets): (current assets / fixed capital): (value of own working capital / current assets)
In Russian theory, financial leverage, depending on the data source, is estimated using one of several methods:
1. According to accounting.
In this case, only long-term loans are taken into account, and short-term loans are not taken into account. The critical value of the coefficient is equal to unity, and a zero value indicates that the company manages mainly by its own means.
2. Based on tax reporting (income statement).
Two formulas are used in this method, depending on whether there is historical data to calculate. If yes, then the calculation is performed as follows:
PL = ∆PP / ∆OP, where
FL - financial leverage;
∆ - change in net profit;
∆OP - change in operating profit.
If historical data are not available, then apply the following formula:
DFL = OD / (OD-P), where
DFL - financial leverage;
OP - operating profit;
P - the amount of interest on loans and borrowings.
The minimum value of an indicator calculated by this technique is equal to one.
3. Based on methodological recommendations.
In this case, the amount of all liabilities, regardless of the period, is included in the structure of borrowed capital.
The effect of financial leverage is another important parameter that allows you to quantify the use of borrowed funds. It is determined by the formula below:
EFL = (1 - NP) * (KR - SK) * / , where:
EFL - the desired effect of financial leverage,%;
NP - decimal expression of the income tax rate ;
KR - profitability ratio of all assets of the company,%.
SK - the average value of the interest rate on the loan,%.
ZK - the value of borrowed capital.
SK - the value of equity.