Financial leverage is a mechanism that refers to the impact of the use of debt on the financial profitability of a company.
It is an integral part of the diagnosis of the return on equity and depends on the rate of return on the economic asset and the cost of the debt.
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Debt can have a positive impact on the return on equity when the company uses it, for example, to finance a production tool.
The leverage effect also makes it possible to use debt to increase one’s investment capacity in real estate, for example. Finally, it is found in many derivative products (complex financial products) such as options.
What is the principle of leverage?
The leverage effect makes it possible to benefit from the effects of a financial return greater than the return of all the funds invested. Thus, in some cases, the more a company is in debt, the more its financial profitability increases.
Debt the cost of which is lower than economic profitability will have a positive effect on the rate of return on equity.
If not, the leverage is reversed. This is referred to as a club effect or a boomerang effect.
The leverage effect can be of interest in all sectors of activity, with the possible exception of large-scale distribution which benefits from a negative working capital requirement.
Calculation of leverage
This leverage effect can be calculated by the following formula:
Leverage = Financial profitability (Rcp) – Economic profitability (R.co)
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With a profitability calculation which is done as follows:
Financial profitability = net income / equity
Economic profitability (Re) = operating result / capital employed (or economic asset)
Capital employed = equity + debts
The formula can also be set as follows:
Rentabilit financire = [Re + (Re – taux d’intrt des emprunts) * (dettes financires / capitaux propres)] * (1 – corporate tax rate)
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The result of the difference is favorable when the leverage effect is positive, that is to say that the use of debt allows the improvement of financial profitability.. Otherwise, the use of debt has a negative effect on financial profitability.
How to calculate the leverage effect?
The leverage effect is calculated from the economic profitability and the financial profitability taking into account the tax.
Economic profitability is the operating profit divided by economic assets.
Financial profitability is the bottom line divided by equity.
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Example of leverage calculation
Company A acquires a production tool for an amount of 2,000 which constitutes its economic asset.
The effect of indebtedness on the return on capital invested by shareholders will be analyzed through four hypotheses which are as many levers used.
|
Hypothesis 1 |
Hypothesis 2 |
Hypothesis 3 |
Hypothesis 4 |
|
|
Economic asset |
2000 |
2000 |
2000 |
2000 |
|
Equity |
2000 |
1000 |
800 |
800 |
|
Indebtedness |
0 |
1000 |
1200 |
1200 |
|
Economic profitability |
20% |
20% |
20% |
5% |
|
Rsultat oprationnel |
400 |
400 |
400 |
100 |
|
Interest rate (cost of debt) |
0% |
5% |
7% |
7% |
|
Charges financires |
0 |
50 |
84 |
84 |
|
Result before tax |
400 |
350 |
316 |
16 |
|
IS (33%) |
132 |
115,5 |
104,28 |
5,28 |
|
Rsultat net |
268 |
235 |
212 |
11 |
|
Return on equity |
13,4% |
23,5% |
26,5% |
1,3% |
|
Leverage |
3,5% |
6,5% |
-3,7% |
In hypothesis 1, we find that without recourse to debt, the profitability generated by the tool (operational profitability after tax) is equal to the net result (268).
In hypothesis 2, with recourse to indebtedness (half equity, half indebtedness) the profitability of the production tool makes it possible to finance the cost of indebtedness (50). This gives rise to a net result of 235 with a higher return on equity than in the first hypothesis (23.5% against 13.4). The leverage effect in this hypothesis is therefore 3.5% (R.cp – R.co), which means that indebtedness plays a positive role in improving the return on equity (around 10% more ).
In hypothesis 3, same principle as in hypothesis 2, we observe an improvement in the return on equity of 3% due to the leverage effect, which is equal to 6.5%. With greater indebtedness the risk of insolvency increases, the interest rate charged by the bank has increased in the same direction, from 5% to 7%.
In hypothesis 4, with the fall in the economic profitability of the tool, which drops from 20% to 5% (following an unfavorable event, a drop in activity, etc.), the operating result is only equal to 100. This allows us to hardly finance the financial charges. The net result is 11, so return on equity was impacted from 26.5% to 1.3%. We are talking about a club effect.
It should also be remembered that in order to benefit from the leverage effect, the financing cost must always be lower than the economic profitability. The production tool must generate significant profitability to avoid the risk of losses.
How to calculate the economic profitability?
Economic profitability is the operating profit divided by the net book value of fixed assets and the working capital requirement.
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