What is financial leverage? How to use financial leverage effectively

Financial leverage is a tool used by businesses in their business to generate high profits. But not everyone can understand what is financial leverage? How to use financial leverage effectively. Come with us to find out about this issue.

What is financial leverage?

What is financial leverage? Financial leverage in English is Financial Leverage, abbreviated as FL. Financial leverage is the extent to which debt is used in the total capital of a business. The aim is to hopefully increase the return on equity (ROE) or earnings per common share (EPS).

In a simpler aspect, financial leverage can be understood as taking the borrowed capital to invest, instead of taking the available capital of the business.

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Groups of indicators of financial leverage

Let’s take a look at the groups of indicators of financial leverage, including:

Total debt/total assets (D/A)

The debt-to-total assets (D/A) ratio measures how well a business uses debt to finance its total assets. It means that of the total current assets of the business to be financed, about what percentage is debt.

This coefficient depends on many factors: the purpose of the loan, the field of business activities, the size of the enterprise, the type of business. To know if this ratio is high or low can be compared with the industry average.

Debt/capital ratio (D/C)

Total Debt/(Total Debt + Equity)

This debt-to-capital (D/C) ratio gives an indication of the financial strength and financial structure of the business. If a business has a high debt-to-equity ratio compared to the industry average, it may be in poor financial condition.

Total debt/equity (D/E)

The debt-to-equity (D/E) ratio reflects the financial size of the business. Thereby showing the ratio of debt and equity the business uses to pay for its operations.

The debt-to-equity ratio is one of the most commonly used financial leverage ratios.

Financial leverage ratio

Average total assets/Average equity

This ratio represents the average debt and equity capital over a period. This low ratio indicates financial autonomy. However, it also shows that businesses have not taken advantage of many advantages of financial leverage.

Interest coverage ratio (EBIT/interest expense)

The interest coverage ratio indicates the extent to which profits before taxes and interest ensure the ability of a business to pay interest.

Financial leverage formula

The magnitude of financial leverage at a profit before interest and taxes is calculated by the following formula:

Inside:

  • EBIT: profit before tax and interest.
  • EPS: return on equity.
  • F: Is a fixed cost of doing business (not including interest).
  • v: Variable cost of 1 unit of output.
  • p: Selling price of the product unit.
  • Q: Number of products sold.

Thus, if the business owner has a capital structure with a larger portion of borrowed capital, there will be a greater return on equity when the profit before tax and interest increases, on the contrary, there will be a return on equity. Ownership decreases more when earnings before tax and interest decrease.

Firms with a capital structure with a larger share of debt will have a greater chance of achieving a higher return on equity, but with it is also associated with greater financial risk.

The impact of financial leverage (DFL)

The degree of financial leverage reflects if the profit before interest and tax changes by 1%, the financial profitability ratio will change by how much%.

Financial leverage is a measure of the debt policy used in running a business. Since the interest payable does not change when output changes, financial leverage will be very large in firms with high debt ratios, and conversely financial leverage will be very small in firms with high debt ratios. short. Firms with zero debt ratios have no financial leverage.

Thus, financial leverage focuses on the debt ratio. When financial leverage is high, even a small change in earnings before interest and taxes can result in a larger change in financial return i.e. financial return. sensitive to variable earnings before interest and taxes.

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Why businesses should use financial leverage

Businesses today are very interested in using financial leverage because:

Financial leverage is a useful tool to boost profits.
Use financial leverage to maintain business operations. Businesses will often use debt, with the aim of covering capital shortfalls. At the same time, the desire to increase the rate of return on equity.

Notes when using financial leverage avoid risks

The use of financial leverage brings great profits, but there are quite a few risks. So to avoid unnecessary risks, businesses should pay attention to the following issues:

  • Businesses need to research and choose reputable sources of loans with the lowest possible interest rates.
  • Businesses need to research and clearly orient their business plans. Specifically, short-term and long-term development areas to use loans effectively.

Conclusion

It can be seen that financial leverage is a tool aimed at improving profits. However, financial leverage also carries a lot of risks. Enterprises need to have a clear business strategy, a plan to use capital properly and effectively.

Through the above sharing, we hope you already know what is Financial Leverage? And there will be optimal plans to use financial leverage effectively.

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