Capital gearing is an indicator describing the indebtedness of an enterprise in relation to its equity. It is also known as leverage (in the US).
Commitments that are borne by the company usually have to be made with interest. Of course, these costs will apply to bank loans or loans. The financial leverage informs about whether the debt service burden is not too high and has no negative impact on the company's profitability. Its level determines the profitability of using foreign capital (e.g. loans).
The financing of foreign capital is aimed at improving profitability and increasing management efficiency. Such financing makes sense until the return on equity is higher. The leverage ratio is used to determine the correctness of the level of debt. A high level of leverage informs that the company may have liquidity problems in the future, activity slows down, capital investment is required and means higher investment risk. Capital gearing also increases dramatically when the company performs buyout.
It should be noted that the leverage has various typical values depending on the industry and type of company. Therefore, when comparing different companies, this should be taken into account.
Capital Lever (Financial)
- To increase the profitability of our equity, we must use foreign capital.
- Leverage will work if liabilities are higher than the rate of interest paid.
- equity is not interest-bearing, which is why it is necessary to take into account the fact that the cost of external capital decreases the basis for the income tax dimension, i.e. it increases the costs of obtaining income.
- profitability adjustment of property includes interest on foreign capital that is already paid and tax at the applicable rate, which is calculated on interest paid already.
It is defined as the level of total credit costs, comparing them to the effectiveness of using own resources. This tool answers the question of whether or not to take out a loan. For example, if we achieve low efficiency from our own funds, it may be likely that we will not pay the loan costs. However, when we achieve high efficiency on our own assets, at the time of collecting the loan, we will achieve through capital supply, additional profits. This is the goal of financial leverage.
Adjusted profitability of assets = net profit + interest - total tax / property
Profitability of assets = Net profit / total assets.
Financial leverage = profitability of own capitals - adjusted value of assets.
If it is a positive value, it means that leverage has worked. A positive effect will occur then, the profitability of the whole enterprise capital will be higher than the interest rate on foreign capital.
EBIT / foreign capital * 100%> ik
Otherwise, the profit generated by the foreign part of the capital will be lower on interest due which will absorb part of the profit generated by equity.
Operational leverage is related to costs in the enterprise and allows to measure the relationship between net revenues from sales and operating profit. There is a scale of flexibility between these variables. The profits we achieve are related to the planned level of sales, but are not proportionate with each other. With the manufacturing capabilities of the enterprise, there is a constant level of fixed costs, the higher it is the higher the differences between the increase in sales and the profit that accompanies the increase. These changes are to present operational leverage and its scope can be presented by means of a modified profit and loss account. The leverage effect can be positive or negative, it depends on the effects caused by a change in production or sales. A higher level of utilization of production capacities may result in a reduction of fixed costs, which results in a higher change in profit depending on the pace of changes in sales.
The total leverage is the product of financial and operational leverage, which we use to determine the degree of financial and operational danger. It combines a change in net income from the forex, operating profit, net profit and return on equity.
- Brierley P., O. (2005). The Determination of UK Corporate Capital GearingBank of England Quarterly Bulletin.
- Eswar S. Prasad, Raghuram G. Rajan, Arvind Subramanian, N. (2007). Foreign Capital and Economic GrowthNBER Working Paper No. 13619.
- Hossain, M. M., & Ahmad, A. (2015). Is Buying Back of Shares a Dangerous Financial Strategy?. Global Journal of Management And Business Research.
- Hossain, M. M., & Ahmad, A. (2015)
- Eswar S. Prasad, Raghuram G. Rajan, Arvind Subramanian, N. (2007)
Author: Izabela Palonek