The beginning businessmen not having the necessary starting capital often resort to loans. Any capital which investors can claim is considered loan. The additional profits got thanks to loans are called effect of a financial leverage.
Example of effect of a financial leverage in banking sector
The financial leverage is a factor on which many other indicators considerably depend. Use of borrowed funds is always risk of bankruptcy because of failures of deliveries, decrease in sales volume, etc. Negative effect of a financial leverage is the situation when profitability is lower than a credit rate. Only large, financially stable enterprises are able to afford high coefficient of the loan capital.
The effect of a financial leverage can be considered on an example: organizations No. 1 and No. 2 have a sum of the used capital on 1 million c.u. The first has no credits, at the second borrowed funds of 400 thousand c.u. under 12%. Operating profit at the organizations identical, is profit taking into account percent 160 and 112 thousand c.u. respectively, net profit – 128 and 89.6. In relation to the equity sum the profitability of the organizations makes 12.8% and 14.9% respectively, i.e. at the organization with the loan capital it is 2.1% higher.
Increase in profitability of the second organization is based on "tax shield" - decrease in the amount of tax on profit which is after payment for percent. Thus, the loan capital is cheaper source of means, than own. However the more borrowed funds, the less steady is the enterprise.
Risks of a financial leverage:
- dependence of the borrower on the investors crediting the organization;
- possible increase in cost of the loan capital or impossibility to consider a credit rate at taxation;
- decrease in volume of gross profit and impossibility to pay according to obligations.
The theory that mortgage crisis in the USA, in fact, was negative effect of a financial leverage in bank is widespread. When the program of mortgage lending began the action, real estate prices and percent were low.
Subsequently housing prices grew, and those people who did not manage to pay the credit began to sell houses to pay off banks. Because of it housing prices fell, and percent because of the increased risks rose. The effect of a financial leverage turned out negative what both people, and national economy in general suffered from.
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