Investing in financial markets is one of the methods that preserves the value of your initial capital and provides the possibility of earning profit. Therefore, investors can make more profitable investments with the knowledge and abilities they have and by using different financial tools. One of these tools is financial leverage. We know that investing in any financial market requires capital appropriate to the target market, and it is possible that your initial capital is not enough for this action. In such a situation, you can get a loan from your brokerage using financial leverage and increase the amount of interest you receive by financing in this way. But you should note that along with the increase in profit percentage, the risk of transactions will also increase.
Just as investors can use financial leverage under the conditions and rules specific to each broker, this possibility also exists for companies and economic enterprises. In order to fully understand these concepts, we suggest you to participate in the macroeconomics course of Rahvard Academy.
What exactly is financial leverage?
Financial leverage is also referred to as capital structure leverage and balance sheet leverage. Financial leverage is a financing method through borrowing. That is, individuals and companies create debt by using it to earn more profit or purchase more assets.
Suppose you intend to invest in the market with 30 million capital, but this capital is not enough for investment. For this reason, you receive a loan of 50 million from your brokerage and invest with the remaining 80 million. After some time, with the growth of the stock, the value of your investment will reach 100 million. Now you return the 50 million brokerage loan and in addition to your 30 million, you have also made a profit of 20 million. In fact, if you had invested with your 30 million, you would have earned much less profit, but by using the financial leverage of the brokerage, you increased your initial capital and earned more profit accordingly.
As another example, suppose a company intends to implement a project to launch a new production line, but the capital required to complete the project is more than the financial capacity of the company. In such a situation, by creating debt, the company will provide the capital needed to start a new production line and increase the profit margin.
Therefore, natural and legal entities try to increase the amount of profit by increasing the amount of initial capital, or increase their assets such as equipment, machinery, tools, etc. by creating debt by using financial leverage. Note that individuals and companies receive loans to create debt and increase assets, and in return they guarantee to lenders that they will repay the principal amount of the loan and its interest. If the asset purchased using financial leverage increases in price and the rate of asset increase is higher than the interest rate of the loan received, the person or company in question will earn more profit and the return on investment will increase. But if the purchased asset experiences a decrease in price, the individual or the company will incur a greater loss. Therefore, it can be said that the use of financial leverage increases the profit or loss of an investment, and this means higher risk.
What is the leverage theory?
The theory of leverage was first proposed by a researcher named Black. He believed that changes in the ratio of debt to assets or the capital structure of a company have an effect on the volatility of the company’s shares. This theory points to the negative relationship between stock risk and stock return. Based on this, it can be said that the lower the stock yield, the higher its volatility, and the higher the company’s stock yield, the less volatility it will experience.
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What is the use of financial leverage in listed companies?
As we mentioned, a part of the financial structure of a company is financed by using financial leverage (debt creation). The managers of the company and its owners, by examining all aspects, recognize the need to use financial leverage and by borrowing, they meet the company’s financial needs in order to increase assets and provide necessary capital for development projects.
On the other hand, it is possible to invite new investors so that financing can be done through the capital of these people. But most companies, between borrowing from banks or institutions and attracting new investors, choose the first way, i.e. borrowing from banks. Because by attracting new investors, the number of shareholders of the company will increase and the profit obtained from the main activities of the company will also belong to the new shareholders and will be divided among them. As a result, instead of increasing the amount of investment, they prefer to go to the financial levers so that the profits from the company’s activities are divided among the previous shareholders.
Pay attention that the use of financial leverage is suitable for companies that are profitable and have the ability to cover borrowing costs. For example, suppose a company finances itself using a loan with an interest rate of 18%. If the company’s profit rate is less than 18%, it will suffer more losses and if the profit rate is more than 18%, it will earn more profit and will not face problems. Therefore, the use of financial leverage, as it increases the potential of profitability, will also increase the amount of risk. This is why analysts, in choosing a company’s stock to buy, check whether most of a company’s economic activities depend on the use of financial leverage. Companies that are less dependent on the use of financial leverage are more favorable options for investment.
What is the use of financial leverage in doing credit transactions?
When the market is in stabilization mode, investors try to increase their profit amount with more initial capital. In this way, the volume of capital market transactions will be done with the help of financial levers and creating debt. In this situation, people try to increase their profit by receiving loans or credit packages from the broker.
People who intend to use financial levers must have a high knowledge of the stock market in order to be able to manage and control their capital in any situation despite the possible market excitement. For example, the fall of the index in 2019 caused multiple losses to investors who used financial levers and made them face more challenges. To get complete information on this matter, we suggest you read the stock market training article.
What is the use of financial leverage in derivative contracts?
A derivative contract is a bond that has no independent value, such as building, gold, or land, and is dependent on the value of currency, goods, or securities. Contracts such as futures contracts, option contracts, forward contracts and swap contracts are examples of derivative contracts and examples of financial leverage. The liquidity ratio and the speed of asset transactions in the derivative market are higher and transactions are less expensive.
In general, the three most common types of derivative market contracts in which financial leverage is used are:
- Future contracts
- Option contracts
- Swap contracts
The use of financial leverage in futures contracts
Futures are divided into two categories: Futures and Forwards. In these transactions, the seller and the buyer of the goods agree that the seller undertakes to deliver the goods to the buyer at a specified time and place with a certain amount and price.
This transaction is similar to the transactions in the stock market. But with the difference that the transaction will be done in the future and at a certain time and the price changes of the desired product in the market until the delivery time will not affect the agreed price of the contract.
Futures contracts have a leverage equal to 10 at the beginning of transactions, and it is possible that this leverage will change according to the security of the transaction and market conditions. For example, let’s assume that investing in the futures market intends to buy a kilogram of saffron and the price of each gram of saffron is 15 thousand tomans. If the saffron futures contracts are in the form of 100 gram contracts, where the guarantee amount for each contract is 300 thousand Tomans, the investor will be required to buy 10 futures contracts and pay 3 million Tomans (300,000 x 10) as the guarantee amount to buy one kilo of saffron.
Now suppose that the investor intends to buy Pushal saffron certificate of deposit in the stock market and the weight of each unit of this certificate of deposit is equal to one gram. In such a situation, to buy a kilo of saffron, one must buy 1,000 units of Poshal saffron deposit certificate and pay 15 million tomans.
Therefore, in this transaction, the financial leverage of the futures contract is five, and the investor can pay three million tomans instead of 15 million tomans to buy one kilogram of saffron, and therefore the profit or loss of the investment will be calculated according to the amount paid.
How is the trading leverage calculated in the futures market?
To calculate the leverage of futures market contracts, the value of the futures contract must be divided by the collateral of the contracts.
For example, using the same method, the financial leverage of the futures contract in the above example is five. Because the value of the contract is 15 million Tomans and the required guarantee for the contract is 3 million Tomans. As a result, if an investor has the ability to earn a one percent return (profit or loss) by investing in the market without leverage, this ability will be fivefold in the derivative market and he will earn a five percent return (profit or loss).
5 = 3000000 ÷ 15000000 = financial leverage
The use of financial leverage in options contracts
This contract is a type of financial leverage in which the buyer and seller agree to give the buyer the right to buy and sell a certain amount of goods in the future for a certain amount. In this contract, the buyer has the right to buy and sell the mentioned asset, but he will not be required to implement it. Therefore, if he wants to, he buys it, if he doesn’t want to, he has the right to sell it, and if he withdraws, he will not be forced to buy the goods and pay the remaining amount of the contract, and he will lose only the amount he paid in exchange for this right. But the seller is required to execute the contract and be ready to sell the said goods. In other words, in this contract, the buyer has no obligation to the contract, but the seller is committed to sell the said goods or assets.
What are the uses of financial leverage in option contracts?
Suppose that you intend to invest with the amount of 20 million Tomans. If the price of “Famli” shares is currently 500 Tomans, you can buy 40,000 “Famli” shares for 20 million Tomans to sell them at a higher price after some time. If after some time the share price reaches 600 Tomans, you will make a profit of 4 million Tomans by selling the share.
Now suppose that instead of buying “Famli” shares at the price of 500 Tomans, you buy the option contract at the price of 50 Tomans. With this, you can buy 40,000 Femli shares with 2 million Tomans of your total money. If after some time the share price has an upward trend, you can sell the contract at a price higher than its intrinsic value, for example, for 120 Tomans and receive 4,800,000 Tomans, and after deducting the initial investment amount (2 million Tomans), on You will earn 70 Tomans per share.
Suppose, instead of 2 million Tomans, you invested all your capital in the form of option contracts, with the amount of 20 million Tomans, you were able to buy 400,000 Femli shares at the price of 50 Tomans, and after some time, with the growth of the share and selling it to At the price of 120 Tomans, you will get 48 million Tomans, and after deducting the initial investment (20 million Tomans), you would have earned 28 million Tomans. But in the case of buying shares under normal conditions, you only earned 4 million Tomans.
You should note that the use of financial leverage, as it increases profitability, will also increase the possibility of making losses and losing capital.
The use of financial leverage in swap contracts
Swap contracts are referred to as exchange contracts. In other words, exchanging, replacing or exchanging an asset or commodity with another asset or commodity is called swap. Swap is an over-the-counter contract with a similar nature to futures contracts that are carried out in the open market
In swap contracts, no money is exchanged and the parties to the transaction agree to exchange their assets or goods with each other. For example, oil and electricity swap.
What are leverage ratios?
Analysts use leverage ratios to check the strength and financial health of a company. On the other hand, banks and financial institutions try to use leverage ratios to measure the company’s financial strength in repaying the loan.
Each of these leverage ratios focuses on one or more factors: debt, assets, equity, and interest costs, and they are examined to find a clear answer to analysts’ uncertainties.
The financial levers of a company are:
Consumer leverage ratio:
This leverage ratio determines how much debt a consumer has relative to their disposable income.
Consumer ratio = total debt of the company divided by disposable income
Regarding the capital of the company:
This ratio measures the amount of financial leverage of the company by comparing the total short-term and long-term liabilities of the beneficiary, compared to the capital of the company, which consists of equity (all forms of shares) plus total liabilities.
Debt-to-capital ratio = total liabilities divided by capital (total liabilities + equity)
The ratio of debt to capital of the company:
This ratio measures the financial leverage of the company by examining the amount of the company’s debts in its financial and capital structure.
Debt-to-capital ratio = (short-term + long-term liabilities) divided by (short-term + long-term liabilities + equity)
Debt to equity ratio of the company:
This ratio is the most widely used and well-known financial leverage ratio in which debt includes all current and non-current liabilities and equity is the amount that investors have invested in the company. Most companies try to keep this ratio on a number less than or equal to 2. A high D/E ratio indicates aggressive financing strategies using debt and this may cause the company’s earnings to fluctuate.
Note that manufacturing companies typically have a higher debt-to-equity ratio.
Debt-to-equity ratio = the company’s total liabilities divided by the shareholders’ equity
The ratio of debt leverage to EBITDA of the company:
This ratio determines whether a company has the ability to repay its debts or will have problems along the way by examining how a company repays its debts and the probability of default in repayments. Most banks and financial institutions use this ratio to pay facilities to companies, and companies try not to exceed 3.
Debt to EBITDA ratio = total debt of the company divided by EBITDA
The degree of financial leverage of the company ( Degree Of Financial Leverage ):
The degree of financial leverage of the company, which is displayed with DFL, is a leverage ratio that is directly related to the cost and examines how the profit per share of this company is affected by the changes that occur in the operating income by making changes in the capital structure. The high degree of financial leverage of a company will indicate the experience of rapid changes in the company’s profit. Therefore, if the operating income of the company increases, the efficiency of the company will also be excellent and will be associated with significant growth.
DFL = percentage change in earnings per share (EPS), divided by percentage change in EBIT
- Note that EBIT is earnings before taxes and interest.
The company’s interest coverage ratio:
This ratio checks whether the company has the ability to pay financial expenses such as interest on facilities, etc., according to its actual and operational activities. Most companies, depending on the industry in which they operate, try to keep this ratio less than or equal to 3 because a high ratio means that the financial costs of the company are higher than its operating income and it is not enough to repay them. Therefore, in such a situation, the company will be forced to get a loan or sell more assets to solve its problems.
Interest coverage ratio = operating income of the company divided by financial expenses (interest)
The coverage ratio of the company’s fixed costs:
This ratio, also known as the interest realization ratio (TIE), compares the company’s cash flow and long-term debt interest, and companies with a higher ratio are considered more favorable companies.
Fixed cost coverage ratio = EBIT divided by the interest cost of the company’s long-term debt
The company’s equity ratio:
This ratio is similar to the D/E ratio except that instead of comparing a company’s debt to equity, it compares the amount of the company’s assets to its equity.
Equity ratio = total assets of the company divided by total equity
Leverage ratio of the first row:
This ratio examines the financial health of banks and measures leverage by comparing the bank’s core capital (Tier 1) or its assets. In calculating this ratio, tier one assets are used which can be liquidated easily and in critical situations.
Tier 1 leverage ratio = Bank Tier 1 capital divided by consolidated assets multiplied by 100
How is the value of assets and profits calculated after using financial leverage?
If you want to calculate the effect of using financial leverage on the value of the company’s assets, just do the following:
Amount of change in asset value = asset x (percentage change in asset + 1)
After calculating the amount of change in asset value, to find out how much profit you have earned by using financial leverage, just add the total capital of the company plus the interest on the debts and subtract from the change in asset value:
The amount of profit or loss using leverage = asset x (percentage change in asset value + 1) – (total capital + debt interest)
An example of using financial leverage and calculating the profit and loss of transactions purchased with leverage:
Suppose someone wants to buy a property worth 100 million Tomans. If he buys this property completely with his own money and after some time the value of the property increases by 40%, the investor has the possibility to sell the property for 140 million tomans and make a profit of 40 million tomans.
Profit or loss using financial leverage = asset x (percentage change in asset value + 1) – (total capital + interest liability)
= (0 + 100000000) – (1 + 0.4) × 100000000
40000000 = 100000000 – 140000000
If the purchased property is depreciated and its value decreases by 40%, the investor can sell the property for 60 million Tomans and therefore will lose 40 million Tomans.
= (0 + 100000000) – (1 + -0.4) × 100000000
– 40000000 = 100000000 – 60000000
Now let’s assume that the investor did not buy this property completely with his own money. If he owns 60 million tomans of the property purchase money and he has received a loan of 40 million tomans with an interest rate of 10%, after a period of time when the value of the property increases by 40%, he has the possibility to buy the property for 140 million tomans. sell it and after deducting the loan interest, he will make a profit of 36 million tomans.
= (4000000 × 0.1 + 100000000) – (1 + 0.4) × 100000000
36000000 = 104000000 – 140000000
On the other hand, if the purchased property is depreciated and its value decreases by 40%, the investor can sell the property for 60 million Tomans and by adding the loan interest to the amount of the loss due to the decrease in the value of the property, he will lose a total of 46 million Tomans.
= (40,000,000 × 0.1 + 100,000,000) – (1 + -0.4) × 100,000,000
– 46000000 = 104000000 – 60000000
Therefore, if financial leverage is used, the potential loss will also increase as much as the potential profit increases.
What is operating leverage?
Operating leverage calculates the fixed costs of a company in a certain period, relative to the variable costs incurred by it. If the firm’s fixed costs are greater than its variable costs, the firm’s operating leverage is high, and this indicates that changes in the firm’s sales volume are sensitive, and as a result, fluctuations may affect earnings before interest and taxes (EBIT) and As a result, it affects the return on investment.
It should be noted that high operational leverage is common in manufacturing companies. Because these companies use a lot of machinery and equipment to produce their products, and these equipment have fixed costs such as maintenance and depreciation.
How is financial leverage used in a company?
The company has many ways to secure its required capital, such as selling common shares, issuing debt securities, using financial leverage, etc. We know that the total equity of a company and its liabilities form the capital structure of the company and it is the management of the company that will shape the capital structure according to the purpose of the company by carefully examining and considering all aspects and risks. Obtain the necessary capital from various financial sources and grow the company in the long term. On the other hand, we know that among the different ways of financing, the use of financial levers is valuable and attractive because of the interest tax shield and will increase the company’s profitability. But if the operating and non-operating incomes that are subject to tax and protect the company’s profit margin are less than the critical amount and are not able to meet the company’s daily needs, the use of financial leverage will reduce the value of the shares and, consequently, the value of the company.
Management must determine how much foreign capital it needs and by examining different financial markets, decide which of the following ways: selling common stock, issuing debt securities, using financial leverage, or a combination of several of the above methods, to achieve It is more practical and less risky.
What are the advantages and disadvantages of using financial leverage?
- It requires relatively little initial investment.
- Borrowers have the option to purchase more property through debt financing.
- If the company’s profit making conditions and process are suitable and the company’s profit rate is higher than the borrowing interest rate, the company will have a higher yield.
- If the profit making conditions of the company are not suitable, the value of the purchased asset will decrease and as a result the company’s profit rate is lower than the borrowing interest rate, the financial losses caused to the company by means of financial leverage will increase.
- In some industries such as the construction industry, automobile industry, oil and oil products, etc., the use of financial leverages brings more operational risks.
- Abusing financial leverage tools may force companies to shut down business and economic activity.
What are the risks of using financial leverage?
Although financial leverage is a tool to increase investment profits, it is possible that the use of this tool entails risks. These risks include:
Changes and fluctuations in stock prices:
The use of financial leverage may cause significant changes in the company’s profit and, as a result, the stock price fluctuates continuously and increases and decreases. This causes the correct accounting of the shares belonging to the company’s employees to be problematic.
Bankruptcy and destruction of the company:
If the company experiences income fluctuations and is unable to repay its outstanding debts and previous obligations, the debtor will file a lawsuit to get the principal of the facility and its interest, and finally, the company’s assets will be auctioned.
Non-payment of facilities by banks and financial institutions or granting loans with higher interest:
In order to pay facilities to companies, banks check different leverage ratios, such as the ratio of debt to equity, and if this ratio is high, they will not pay the facilities or they will pay less facilities or if they agree to pay all the facilities. If they do, they will raise the interest rate to compensate for possible losses.
How to measure the risk of using financial leverage?
Company management uses various ratios, including short-term debt solvency ratios, to measure financial leverage risk. Current ratio and current ratio are two examples of short-term debt solvency ratios and measure the company’s ability to repay short-term obligations. In these two ratios, the company’s current assets are compared with its current liabilities, with the difference that in the current ratio, the ability of a company to convert products or services into cash will be examined, but in the current ratio, inventory and prepayments are part of assets. The company’s current is not categorized and assets that have higher liquidity will be included in the calculations.
The higher the value of this ratio and closer to one, it shows the company’s ability to repay its obligations, and ratios smaller than one indicate the company’s inability to repay its obligations.
Another ratio used to measure financial leverage risk is investment ratios. The ratio of long-term debt to capital and the ratio of total debt to capital are two examples of investment ratios.
The interest coverage ratio is the most well-known ratio that examines the level of financial leverage risk. This ratio shows the company’s ability to make operating income before deducting interest that can cover the company’s financial expenses.
What factors affect the capital structure of a company?
Many factors are considered in creating the capital structure of a company in order to make the best decision. Some of these factors are:
Companies that have high and stable sales will be in a better position to use financial leverage than companies that have low and unstable sales.
Operating leverage of the company:
Companies with lower operating leverage tend to use financial leverage more than companies with high operating leverage due to the stability of fixed costs compared to variable costs and the reduction of profitability fluctuations.
Company growth rate:
Fast-growing companies tend to use financial leverage more than slow-growing companies because by using it and acquiring more capital, they are able to increase the speed of their activities and accelerate the company’s growth process.
Most companies tend to use financial leverage because of the interest tax shield.
The profitability of the company:
Companies with lower profitability tend to use financial leverage more than companies with high profit margins. Because they are not so operationally powerful that they are able to manage and provide their business operations using the internal existence of the company.
Frequently asked questions
What is financial leverage?
Financial leverage is a tool that can be used to increase the amount of initial capital by creating debt. Using financial leverage is usually associated with the goal of obtaining higher profits or purchasing more assets.
What is the use of financial leverage?
- Funding of companies
- Credit transactions by receiving credit from brokers
- Market contracts derived from futures contracts, options contracts, forward contracts and swap contracts
- Conducting transactions in the capital market or outside it, by using interest-bearing facilities
What are leverage ratios?
Ratios that examine the financial health of an economic enterprise or company. In most cases, banks and financial institutions to grant facilities to companies, first measure the financial health of the company in question and the ability to repay the facility and then make a decision about the company. These ratios are:
- Consumer leverage ratio
- The ratio of debt to capital of the company
- The ratio of debt to capital of the company
- The ratio of debt to equity of the company
- The ratio of debt leverage to EBITDA of the company
- The degree of financial leverage of the company
- The company’s interest coverage ratio
- The company’s fixed costs coverage ratio
- Equity ratio
- Leverage ratio of the first row
What are the risks of using financial leverage?
- Bankruptcy and destruction of the company
- Creating fluctuations in stock prices
- Non-payment of facilities through banks or payment of financial facilities with higher interest
As we mentioned in the article, the use of financial leverage has various uses. When we get a loan from a bank to buy a property, land, car or equipment, we have used financial leverage.
By using financial leverage and using credit packages, stock traders can enter valuable trades with more initial capital and earn more profit than when they entered a stock with little money.
By using financial levers, companies have the possibility to provide the capital needed to complete and implement development projects and plans, purchase equipment and their investments, and by accepting a reasonable risk, increase the profit margin of the company and the profit that belongs to the shareholders and The owners of the company multiply it.
But along with all these advantages, we must note that the use of financial leverage, as much as it can help and increase the potential power of profit-making, also entails the risk of increasing and multiplying losses.