The effect of financial leverage: the concept of profitability...

6.5. The effect of financial leverage: the concept of profitability and the concept of risk

The ability to change the capital structure, "safety" additional borrowing can be assessed using a tool such as a financial leverage effect.

The financial lever (Financial Leverage, FL) is one of the characteristics of the relationship between debt and equity. From the analyst's point of view, it is an assessment of the use of loans on the basis of the components of the financial leverage, when the capital borrowed at interest can fulfill the role of investments yielding a profit higher than the interest paid. The equity capital in this case is considered as the foundation for attracting borrowed funds and the appearance of the so-called financial leverage effect (Degree of Financial Leverage, DFL).

Generally, DFL is treated as a leveraged loan with a fixed interest in order to increase the profit of holders of ordinary shares. At the same time, debt obligations should bring in a greater income potential than interest payments on these obligations. As a result, the company can increase the efficiency of using its own capital.

If literally leverage is a lever for moving weights, then in the economic sense of the word it is a certain factor, a minor change of which can lead to a significant change in the effective indicator. Thus, by influencing the cost structure, changing the ratio between fixed and variable costs, one can influence profit before taxation and interest payments; a change in the structure of capital will entail a serious fluctuation in the amount of net profit.

Thus, DFL characterizes the relationship between capital structure, net profit and return on equity by net profit. In other words, it can be defined as a potential opportunity to influence profit as a result of borrowing; changing the structure of capital.

However, it should be remembered that the level of the effect of the financial lever is directly proportional not only to the return on equity of net profit (net profit/equity), but also to the degree of financial risk of the company. It looks like a double-edged sword: on the one hand, the company gets an opportunity to increase the profitability of its own funds, on the other hand, additional loans entail increased risks.

Indeed, the higher the level of interest towards payment (fixed costs), the lower the net profit. Thus, the higher the FL level, the higher the company's financial risk. Therefore, it is possible to assess the change in the capital structure from different points of view. Based on this interpretation of the financial leverage effect, two key concepts of DFL:

1) the European concept (the concept of return on capital);

2) the American concept (the concept of financial risk).

The first concept of DFL is considered as the reasonable use of fixed-payment debt to finance those assets that promise an income that exceeds interest payments. The effect of financial leverage is manifested in the increment of profitability of equity capital, increasing the profitability of own funds.

Example 6.2

Three firms ("A", "B", "B") have the same value of assets (2000 den. units), but different structure of sources of their formation: "A" has no borrowed funds, and "B" uses loans more than B .

On the basis of available data, determine:

a) which firm will receive the maximum increase in return on equity,

b) what is the magnitude of the effect of the financial leverage.

Company B :

DFL = 2/3 o (30 - 15) o 1 = 10%.

The calculation results show that the company "A", not using borrowed funds, does not receive any additional effect.

The company B & quot ;, risked taking advantage of strangers cash, has an increase in return on equity of 10%. The value of DFL will vary depending on the size of the return on assets, the interest rate and the ratio of the company's own and borrowed funds. Thus, the company "B", which has a larger than "B", the share of terrestrial capital in the balance currency (1500 den. Units) and, accordingly, the higher interest rate (18%), received an increase in the return on equity of 24 %, which is 14% larger than the B & quot ;.

So, the first conclusion that can be drawn is that the effect of a financial leverage will be greater the greater the excess of the profitability of assets over the interest rate on loans and the greater the ratio characterizing the ratio of debt to equity.

Next, we determine what factors determine the company's ability to additionally raise borrowed funds, whether it can optimize the capital structure, focusing on future borrowings.

For this purpose, it is recommended to formalize the calculation of the financial leverage effect:

Formula calculation Rsk:

The effect of the financial lever has two components (Figure 6.1).

Formalizing the calculation of the effect of financial leverage

Fig. 6.1. Formalizing the calculation of the effect of financial leverage

The differential reflects the degree of coverage of the average calculated interest rate by the level of economic profitability of investments in the company's assets. The lever arm, or the coefficient of financial leverage, is the essence of the capital structure.

The product of these two components, adjusted for the tax coefficient (taxes reduce the size DFL), and gives us the magnitude of the desired effect.

Using this expression, you can calculate the return on equity (Rsk):

This indicator determines the border of economic expediency of attracting borrowed funds. The semantic content of this expression - while the profitability of investments in the enterprise is higher than the price of borrowed funds, i.е. the differential is positive, the return on equity will grow the faster, the higher the ratio of borrowed funds and equity. However, as the share of borrowed funds increases, their price rises, profits begin to decline, and the profitability of assets also decreases. Consequently, there is a threat of obtaining a negative differential and, accordingly, a negative effect of the financial leverage.

Example 6.3

parsing a sample job

Justify the choice of sources of financing (distribution of risks between owners and creditors).

To finance a business, you need 1,000 thousand den. units Using these funds, the company plans to receive an operating profit of 180 thousand den. units

There are three options for the ratio of equity and borrowed funds in the company's capital.

The company receives the maximum increase in return on equity (18.2%) under option II of the capital structure, despite a higher financial leverage ratio (4 vs. 1.5 for variant III).

Now we can draw another conclusion: in order for the EGF to be positive, it is necessary to regulate the debt-equity ratio, select the leverage of the leverage, focusing on the value of the differential. This assumes that analysts carry out variant calculations in relation to the specific conditions and capabilities of a truly functioning company.

Can the company more accurately determine the boundaries of changes in the capital structure, calculate the amount of profit necessary to receive a positive DFL

In order to solve the task, it is necessary to calculate two indicators: the point of indifference (TB) and the financial critical point (FCT) 1.

o Indifference point is the profit before interest and taxes, at which the return on equity is not changed in the case of borrowing.

Financial critical point is profit before interest and taxes, the amount of which is equal to the amount of financial costs associated with debt servicing.

Example 6.4

Suppose the company shows the following data in the financial statements by the end of the reporting period:

o Own capital - 150 million den. units;

o borrowed capital - 42 million den. units;

o Profit - 23 million den.;

o income tax rate is 20%;

o interest rate on loans - 19%. We calculate the magnitude of the effect of the financial leverage:

Due to the fact that the profitability of assets is lower than the cost of borrowed funds, the company has a negative effect of financial leverage (with borrowing funds, return on equity is reduced by 1.57%). What should be the size of the profit from the main activity, so that the EGF would be zero?

Calculate the point of indifference.

If EFF = 0, then Pg - SP = 0, hence PA = SP; P = PA o A = 0.19 x 192 = 36.48 million den. units

Having a profit of 36.48 million den. units, the company can use borrowed capital (mixed business financing scheme), but the return on equity will not increase. Define the return on equity of net profit (PE) in terms of borrowed capital and with a short-term scheme for financing activities.

Mixed business financing scheme:

Рек = ЧП/СК = (1 - 0,20) o (36,48 - 7,98)/150 = 15%. A short-term business financing scheme:

Рsk = ЧП/СК = (1 - 0,20) o (36,48 - 0)/192 = 15%.

The calculations show that in this case, the EGF is neutralized, therefore, the company must earn a profit greater than at the point of indifference in order to obtain the desired increase in return on equity (EGF> 0).

Well, what is the level of the financial critical point, i.e. what is the bottom border of profit, sufficient only to cover financial costs (interest amounts, etc.)?

Obviously, at this point, Pk = 0, then Π = 3K o CP,

P = 42 o 0.20 = 7.98 million den. units

With a profit margin below 7.98 million den. units the company will become unprofitable.

Thus, certain profit margins are established, focusing on which managers can make decisions about changing the capital structure:

1 . Pfact & gt; TB - in this case, the EGF is positive, and it is profitable for the company to raise borrowed funds.

2. Pfact = TB - the use of borrowed capital will not change the financial result and, accordingly, the value of

Rivers -

3. FCT & lt; Pfakt & lt; TB - with a mixed business financing scheme, the EGF is negative.

4. Pf.1TT & lt; FCT - in the presence of profit before interest and taxes, the company has net losses.

The second concept in & yen; 1 treats it in terms of the degree of financial risk. The attraction of borrowed funds by the company involves not only a potential opportunity to increase the return on equity, but also with increased financial risks.

Risk manifestations:

o possible decrease in solvency;

o possible decrease in shareholders' earnings per share.

A company with a significant share of borrowed capital is recognized by the organization as financially dependent, with a strong leverage of the financial leverage. The higher the level, the higher the company's financial risk, which may manifest itself in a decrease in solvency, an increase in the threat of non-repayment of the loan, the fall of dividends and the stock price.

Obviously, the financial lever inherent in the duality, due to the need to choose an alternative option: risk-income. Growth/7/leads, on the one hand, to an increase in the risk of holders of ordinary shares, on the other hand, it can provide revenue growth per share. At the same time, the growth of the expected income is likely to entail an increase in the market price of the share, an increase in the risk, in turn, will lead to a decrease.

The purpose of using an instrument such as P1 is to find the optimal balance between risk and expected income in order to maximize the market price of the company's shares. Financial leverage means the inclusion of debt in the company's capital structure, which yields a constant profit.

Within the framework of the concept of financial risk, the coefficient is calculated - the force of the financial leverage [p). In this case, the ratio of the increase in net profit per share (%) and the increase in operating profit (%) is determined. This ratio shows how many percent of net profit per ordinary share will change when operating income changes by x percent:

The higher the strength of the financial leverage, the greater the financial risk.

Thus, the definition of a reasonable, suitable source-specific company structure is one of the most visible and accessible ways to analyze the company's financial stability. Ultimately, the development of dividend policy, the correct choice of external (lending, issue of shares) and internal (undistributed profit) sources of financing depend on the relationship between own and borrowed capital. It is sufficient amount of own funds that can provide the company with serious development rates and some degree of financial independence.

If you find the optimal ratio of own and borrowed funds should be taken into account: the company's development prospects, its strategy, the level of risk for which the owners are ready to go, the real interest rate forecast, and the tax consequences of a different ratio of own and borrowed funds.

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