The effect of financial leverage has the following components:
- the differential, which is determined by the difference between the rate of return on assets and the average estimated interest on loans;
- leverage, which is calculated as the ratio of borrowed to own funds.
From this concept follows the five basic rules of a cash loan:
- The profitability of the new borrowing depends on the differential value obtained in the future. In this case, you need to carefully monitor the fluctuations of this indicator. So, while building up “leverage”, the bank compensates for the occurrence of risk by raising the price of a loan. Sufficient opportunities in this direction have enterprises that have a large margin of differential.
- The lender's risk is inversely proportional to the differential. So, with a larger indicator, there is less risk, with a lower value, it accordingly increases.
- When considering the possibility of obtaining a loan during settlements, it is necessary to exclude the amount of accounts payable.
- The financial stability of the enterprise depends on the specific weight of the loans, so you should be very careful when obtaining new loans.
- The optimum level of loans is considered to be their specific gravity of 40 percent of all assets of the enterprise. The specified indicator is equal to the value of the lever 0.67.
With an increase in the share of loans in the balance sheet structure, financial leverage increases, which is able to generate a certain risk. And this is already a prerequisite for becoming dependent on lenders in case of untimely repayment of loan funds, which in turn leads to a loss of liquidity of financial stability.
For banking institutions, it is very important that the potential borrower does not have a negative differential value. Some experts in the economic sphere believe that the effect of financial leverage in order to achieve their optimality should equal one third of the return on assets.
In other words, the profitability indicator depends on the successful regulation of the size of a given quantity. Only at this value does the effect of financial leverage show the likelihood of compensation for tax exemptions and provision with own funds.
For a detailed acquaintance with these concepts, it is necessary to understand the principle of operation of financial leverage and the formula by which it is calculated.
The effect of financial leverage determines the fluctuation in the value of net profit per share, calculated as a percentage. So, in the calculation of the differential, indicators are taken into account taxation, i.e. two thirds of the difference in profitability and interest rate received. Taking into account the definition of the lever arm, we can derive the following formula:
EGF = 2/3 (ER - SP) * ( / ),
where ER is economic profitability.
JV - interest rate on loans.
AP - the amount of borrowed funds.
SS - the amount of equity.
Based on the formula, we conclude that when forecasting the activities of the enterprise in the financial and economic sphere, it is necessary to take into account the leverage depending on the value of the differential.
Calculating the optimal effect of financial leverage is a task from the realm of fiction. Indeed, having today a favorable leverage, it is not known what tomorrow will be the economic profitability and interest rate (differential). Thus, the attraction of additional funds in the form of loans is both an incentive to the development of the enterprise, and a certain risk of material losses in the future.
Therefore, the main task of the manager of any company lies in the exclusion of all financial risks, taking only calculated, using the effect of financial leverage.