As a manager, you know that it is not always easy to get the necessary resources to invest in business expansion. At these times, several obstacles arise, preventing access to credit. Not surprisingly, it is common for many companies to use financial leverage to invest in their growth.
However, this mechanism, although it helps in the expansion of the enterprise, has a series of risks that must be observed by those who want to make good use of it without endangering the continuity of the enterprise. With that in mind, in this content we will explore all the intricacies of this type of operation. Good reading!
What is financial leverage?
It is an operation by which the investor or manager of a company increases its potential for profitability or profit from a value greater than what it actually has available. Normally, this procedure is done on the basis of a credit operation.
Did not understand? Calm down, let’s explain in other words. Imagine what the function of a lever is and in what situations you would use one. Almost always, this tool is used when you want to use more force to complete a certain action.
That is, when we think of financial leverage, we are referring to the practice of someone using external resources (such as borrowed money) to achieve better results that would be impossible without this help.
Think that you have a factory that, due to the good work done, receives more orders every day, exceeding the production demand currently available. What to do to not miss opportunities? In this scenario, the business manager seeks credit in the market and, with the money raised, expands the production facilities.
Thus, the positioning is improved to face the new demands to take advantage of the opportunities that appear. Even with the contracted debt, the administrator will expand its production, earn more, pay for the borrowed money and even increase profit. Without that lever, perhaps none of this would happen.
It is important for the manager to know the differences between financial and operating leverage. While the first involves the investment of external resources, usually raised from credit operations, the second is closely linked to the fixed costs of a business and how they are used to increase the growth of an enterprise.
Operating leverage is almost always adopted by businesses where these values are quite heavy, especially when compared to variable costs. In these scenarios, fixed costs assume the role of leverage, causing companies with intense demand for them to further increase operating profit.
In a simplified example, a business that has a 25% increase in business can have a 30% increase in operating income. This is because fixed costs represent expenses that do not vary with the level of production or the volume of sales. In the opposite direction, variable costs fluctuate along with revenues, going up or down as sales increase or decrease.
In this way, operating leverage aims to make production or sales generate more revenue without having to significantly increase fixed costs. In the end, the expectation is to achieve a greater profit.
How to calculate the degree of financial leverage?
Although it brings some advantages, this operation has some risks. Therefore, it is important to monitor the evolution of indicators as the operation is developed. For this, there is the so-called Degree of Financial Leverage , which, as its name implies, measures the index of the enterprise at a given moment.
Roughly speaking, the GAF calculation consists of dividing the income before interest and income tax by the income before income tax. In other words, it is calculated with the following formula:
Earnings before interest and income tax (EBIT) / earnings before income tax (EBITDA)
The result will be an index that can be favorable, unfavorable or null. Whenever the calculation indicates a GAF greater than 1.0, leverage brings positive returns. When the account shows a result equal to 0, it shows that there is no leverage or that it is not making a difference. Finally, if the GAF is less than 1.0, it is a sign that the operation is not providing enough return to cover what was invested.
How to control the risks in this type of operation?
Among the main risks within an investment strategy based on financial leverage are:
- having expenses greater than income;
- not bear the payments related to the contracted credit;
- Make the company less attractive to future investors.
Before making the decision to use leverage, it is essential to consider some aspects to more accurately measure the risks to which the company will be exposed. So take into account:
- the current level of indebtedness;
- the interest charged;
- The profit you want to achieve.
There are some alternatives for those who plan to invest, but do not want to incur debt to conduct the operation or see the interest charged as an obstacle to this: it is common for companies interested in expanding their activities to sell assets or divide the capital of the business through the issuance of shares in the financial market.
However, it is worth mentioning that, from the moment the company is publicly traded, it is necessary to constantly report to shareholders and share part of the profit with them, at the risk of seeing the company’s shares devalue. When this happens, it becomes less attractive to other investors and sees its market value fall.
Considering all this, with a careful analysis of all the risks and within a careful planning, financial leverage is an interesting instrument for the growth of a business, without compromising the financial health in the medium and long term.
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