Financial Leverage

We understand leverage as the use of borrowing to finance a project, as we are currently emerging from a great economic crisis any debt involves a thorough analysis of their advantages and disadvantages in order to determine how long it will affect the financial cost of our debt our utilities. The financial leverage is deemed to be bad when it has a negative effect on the profitability of the company and is good when its effect is positive.

For example, if our cost of funding is equal to or greater than our profitability is not a good deal, since if for example we are indebted to pay 100 or 120, is not good business and therefore we reject the project.

But if the cost of funding is less than our utility, that is an interesting option. For example we produce into debt at 100 and 400, not only pay our loan but we have a surplus in this case is worth borrowing but I always assume it with caution taking into account the following aspects:

1 .- The company currently has to be economically viable ie make a profit, because if a company is lost would be impossible to obtain credit, or risk a debt.

2 .- try to measure our risk by making a projection of our budget where we observe our projected financial statements but in three different scenarios: optimistic, optimistic and pessimistic, analyzing the consequences of each one for our business.

3 .- With the different scenarios we can measure which would better know our risk.

4 .- If there is much uncertainty into debt we can not think because any change of scenery can seriously affect our financial structure

As we can measure our level of indebtedness

We have the following formulas or financial indices which allow us to know our level of indebtedness

1) .- Leveradge total = Total Liabilities / Equity

This index shows the degree of commitment of the assets of the partners or shareholders to creditors of the company.

For example, if this index is 2 (or even 200%) means that the estate is committed twice with creditors or in other words in a bankruptcy partner would receive nothing because the company’s debts exceed the contribution made to partners.

But if this index is 0.5 means that the property is committed by 50% this is ideal for banks and higher borrowing that will seek higher returns using only debt.

2) .- Short-term leverage = Current Liabilities / Equity

This indicator shows us our debts in the short term or terms of heritage is committed to short-term debts.

GAF = Degree of Financial Leverage
EPS = Earnings per share
EBIT = Earnings Before Interest and Taxes
I = Interest

GAF = △% UPA / △% EBIT

Maintaining an adequate level of financial leverage can increase our profitability and our leverage ratio should not exceed or be raised too much for there will be a negative impact on our corporate image and the financial strength of our company.

Article wrote by Lucio Ayala

Tags:   economic crisis · financial cost · financial leverage · profitability