What is financial leverage, should you use financial leverage, how much is appropriate to use the groups of financial leverage indicators… The following article will give you the answer.
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What is financial leverage?
Financial leverage is a widely used term in the business field, which is simply understood as the use of other people’s money for the purpose of making profits for themselves, the use of financial leverage. Wisdom will help bring great benefits. However, there is also a downside that not always using financial leverage also brings good results. The use of financial leverage is a double-edged sword, if used well, it will bring great results, but if not used well, it will cause unpredictable consequences.
In other words, financial leverage is the activities related to the use of debt to obtain benefits, profits on additional assets for individuals or organizations using financial leverage. It can be understood simply as a form of borrowing money or property of an individual or an organization with another individual or organization in order to bring profit to the borrowing individual or organization.
Using financial leverage is the combination of liabilities and equity in operating financial policies of enterprises. Naturally, Financial leverage is large in businesses with a higher ratio of liabilities than equity and vice versa.
Financial leverage index groups
Financial leverage is always a double-edged sword. If they are used effectively and implemented correctly, they will bring enormous advantages to the business, accelerating the process of profitability for the business strongly. However, if the business situation becomes worse than expected, it can be a “nightmare” for business owners.
According to economic analysts and business owners from large corporations, there is no specific figure for how much financial leverage is appropriate. This completely depends on how the capital is used as well as the business owners’ ability to accurately predict the business situation. Enterprises can rely on the average index in the industry as a basis to determine the appropriate ratio for their business.
There are very few businesses that can proudly say they have no debt. Meanwhile, most companies have to take out debt at a certain point in time to buy equipment, build new offices or pay employees. For investors, whether they dare to challenge themselves to invest depends on whether the institution’s debt levels are sustainable. To evaluate this, financial leverage ratios are the factors that should be considered first. A low or high leverage factor can be calculated using the leverage measurement.
Debt/Total Assets Ratio
The debt-to-total assets (D/A) ratio measures how well a business uses debt to finance its total assets. This means about how much of the total current assets of the business is financed by debt.
This ratio, if high, represents a disadvantage for creditors but is beneficial for owners if the capital used is highly profitable. However, this index is too low, which also implies that enterprises have not taken advantage of the debt mobilization channel, which means they have not exploited financial leverage well.
The debt-to-total assets ratio depends on many factors: the type of business, the size of the business, the field of activity, the purpose of the loan. Therefore, to know if this ratio is high or low, it must be compared with the industry average.
To be able to correctly comment on the ratio of total debt to total assets, it is necessary to combine with other ratios, but if the ratio of total debt to total assets is high, then we can conclude that in the future the business it will be difficult to mobilize loans to conduct production and business.
The debt-to-capital (D/C) ratio measures the financial size of a business and shows how much of its total capital is debt.
A D/C provides analysts and investors with an overview of the financial strength of the business, its financial structure, and how the business can pay for its operations. its motion.
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A business that has a high debt-to-equity ratio relative to the industry average may not be in a very good financial position right now because debt will increase the burden as well as the risk to the business. with business.
Debt-to-equity (D/E) ratio reflects the financial size of the business, we know the ratio of debt and equity that the business uses to pay for its operations. The debt-to-equity ratio is one of the most commonly used financial leverage ratios.
If the D/E is greater than 1, it means that the business has borrowed more than its existing capital, and the business may be exposed to debt repayment risk and the risk of bank interest rate fluctuations.
However, the use of debt also has advantages certain, that is the interest expense will be deducted from corporate income tax. Therefore, a low D/E may mean that the business has a low risk of debt repayment, but it can also show that the business does not know how to borrow for business and especially to exploit the benefits of efficiency. tax savings.
Therefore, businesses must consider financial risks and advantages of debt to ensure the most reasonable ratio.
Financial leverage ratio
This ratio represents the relationship between debt capital and owner’s equity. The financial leverage ratio uses averages because the data of total assets and equity at the end of the period is not representative, so it does not reflect the actual changes as well as the situation. financial position of the business over a period of time.
This low ratio shows that the enterprise’s financial autonomy shows that the enterprise has not yet known how to take advantage of many financial leverage advantages. This coefficient also allows assessing the positive or negative impact of borrowing on ROE. As we know ROE can be calculated by dividing average net return on equity.
Loan interest payment coefficient
The interest coverage ratio indicates the level of profit before taxes and interest when ensuring the ability of a business to pay interest.
This ratio represents how much profit before interest and tax (EBIT) is available for each dollar of interest expense. The higher this indicator, the better the ability to cover interest expenses. If the above ratio is greater than 1, the enterprise is fully capable of paying its interest. If it is less than 1, it means that the business has borrowed too much compared to its ability, or the business is so poor that the profit before interest and tax (EBIT) earned is not enough to pay interest.
People often wonder whether borrowing or keeping debt is a good or bad sign. In this case, the answer could be yes or no. Because for example, a company is preparing to open a new warehouse because of business expansion needs. Now, this company will need some money to build the warehouse. To get this money, they may have to take out a loan. Therefore, the company expects sales to skyrocket in the near future to offset borrowing costs.
Because interest is a non-taxable expense, debt is becoming cheaper and cheaper. This in turn makes debt a way to establish assets versus equity. However, problems will arise as this debt increases. Large amounts of debt can turn into a burden for any business. And in the worst case scenario, bankruptcy is a completely possible scenario.
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With this article, we hope that customers can consider more carefully for loans to avoid falling into bad debt groups.