Financial leverage is something that can bring benefits to a company. With it, the company can make investments and achieve good profits, even if it does not have enough equity to do so.
This term is common in several investment areas, and it is not something simple to do, because despite bringing some advantages, it also has its risks. Therefore, let’s see below what it is, how it works and what are the risks and advantages that financial leverage brings.
What this article covers:
What is financial leverage?
A lever is a tool used to lift heavy objects without straining too much. This is the concept of financial leverage. With it you can reach profits much faster than usual.
We can then say that it amplifies the return on a given investment. With financial leverage it is possible to have high profits, even if you have invested little. But how is this possible? Let’s understand better.
How does a company’s financial leverage work?
Let’s say that a company wants to carry out a certain action but does not have enough resources to carry it out. In this case, through an external investment, the company can perform the action it intended, and then upon reaching the profit, the company pays the investment and still makes a profit.
To make a financial leverage, the company can use a series of resources, such as loans, rent, financing, etc. Thus, in financial leverage, the company seeks to achieve profits through indebtedness.
What advantages does the financial leverage of companies have?
The advantage that financial leverage brings to a company is the possibility of making a good profit, even with little or no investment. If financial leverage is a success, the company makes a good profit for itself and gains the opportunity to make new investments without the need for further leverage.
But by enhancing earning capacity, leverage increases investment risk. Let’s look at the risks of financial leverage.
What are the leverage risks for companies?
Just as gains are enhanced by financial leverage, so are risks. The company will go into debt when making financial leverage, and this is inevitable. If the leverage really works that won’t be a problem, but there are also chances that it won’t work.
If this happens, the company will have serious problems, as the loss it will have in financial leverage will be much greater than that of any other investment.
How to calculate the financial leverage of a company?
To calculate your company’s financial leverage, you must first calculate what your company’s earnings before income tax (LAIR) is. You can do this by subtracting pre-tax earnings from interest.
Thus, if the company’s EBIT is 75,000, and the interest is 15,000, the company will then have an EBIT of 60,000. After that, to calculate the degree of financial leverage (GAF) you will split the EBIT of your company through LAIR. If we do this calculation using the same numbers as before, then we have a GAF of 1.25. But what does that mean?
How to measure results?
If the GAF score is less than 1, financial leverage will not bring profits to your company. If it’s 1, leverage won’t bring you losses, but it won’t give you profits either. But if the GAF result is greater than 1, leverage has good potential to bring profits to your company.
So, if you are thinking of making a financial leverage for your company, do the math and see if it is worth it or not.