When developing financial projections for a business plan, it is important to pay close attention to the capital structure of the business. One way of indicating the capital structure is to calculate the financial leverage ratio which measures the level of debt in relation to the level of owners equity.
A business with a high level of debt (sometimes referred to as being highly geared) is considered to be more risky as finance costs need to be paid before equity owners get their return. However, in return for this higher risk a high level of debt will give greater returns to the owners provided cash and profit are managed correctly.
So there is a careful balance to be maintained between the levels of debt and equity. High financial leverage will increase the return to the equity owners but the business must have the ability to be able to pay the finance costs such as interest and charges, and ultimately to repay the loan principal. In contrast, low financial leverage will provide a less risky business, but will also produce lower returns for the owners.
Using Financial Leverage to Increase Equity Returns
Business funded by Equity
As an example, suppose a business is funded entirely from equity (money injected by its owners and retained earnings) of 400,000 and has a net income of 60,000 for the year. In this case the financial leverage is zero, and the return on equity is 60,000/400,000 = 15%.
Financial Leverage 100%
If the same business is now funded by debt and equity in equal amounts with 200,000 provided by the owners, and a further 200,000 provided by a long term bank loan at an interest rate of 6% (debt), the financial leverage is given as follows:
Financial leverage ratio = Debt / Equity Financial leverage ratio = 200,000 / 200,000 Financial leverage ratio = 100% or 1 or 1:1
The business now has interest on the loan to pay of 200,000 x 6% = 12,000, and so, all things being equal, its net income falls to 60,000 – 12,000 = 48,000. However, although the earnings are lower, the return on equity to the owners is now 48,000 / 200,000 = 24%.
The equity owners return has increased because the business earns 15% but only pays the bank 6%, a difference of 9%. So the total return to the owners is 15% on their own money of 200,000 and 9% on the banks money of 200,000 giving a total of 24%, as shown below.
Return to owners = Return on own money + Return on debt Return to owners = 200,000 x 15% + 200,000 x 9% = 48,000 Return on equity = 48,000 / 200,000 = 24%
Financial Leverage 300%
If the amount of debt is increased even further to 300,000 and the equity provided is 100,000 then the financial leverage is now given as follows:
Financial leverage ratio = Debt / Equity Financial leverage ratio = 300,000 / 100,000 Financial leverage ratio = 300% or 3 or 3:1
The business now has interest on the loan to pay of 300,000 x 6% = 18,000, and so, all things being equal, its net income falls to 60,000 – 18,000 = 42,000. However, the return on equity is now 42,000 / 100,000 = 42%.
The effect of the higher financial leverage is to increase the owners return to 42%, an increase of 27% on the original return of 15%. Again, the owners have earned 15% on their own money but have also earned a 9% return on the banks money, since the debt is 3 times the equity, the financial leverage multiplier is 3 and they have earned an additional 9% x 3 = 27%, giving a total of 42%, as shown below.
Return to owners = Return on own money + Return on debt Return to owners = 100,000 x 15% + 300,000 x 9% = 42,000 Return on equity = 42,000 / 100,000 = 42%
Providing the business can afford to pay the interest and repay the debt when it falls due, then the equity owners continue to earn higher and higher returns as the financial leverage increases.
The Economy Turns
But what happens when the economy turns and interest rates rise. Suppose the business can now only generate profits of 38,000 instead of the previous 60,000, and bank interest rates increase to 12%.
In our business with zero financial leverage, the owners still make a return on equity of 38,000/400,000 = 9.5%. This is lower than before, but the business survives.
For our business with the high financial leverage of 300%. the interest is now 300,000 x 12% = 36,000, and the net income is 38,000 – 36,000 = 2,000. The return on equity is now 2,000 / 100,000 = 2%.
The equity owners return has decreased because the business earns 9.5% but pays the bank 12% a difference of -2.5%. Since the debt is 3 times the equity, the financial leverage multiplier is 3 and the owners have lost 3 x 2.5% = 7.5%, their total return falls to 9.5% – 7.5% = 2% which is demonstrated below.
Return to owners = Return on own money + Return on debt Return to owners = 100,000 x 9.5% - 300,000 x -2.5% = 2,000 Return on equity = 2,000 / 100,000 = 2%
Financial leverage can improve the returns to equity owners is the business is profitable, able to cover its interest payments, and has the cash flow to repay the debt principal. However, if there is a downturn in the business, the effect of the high financial leverage is to amplify the decline in the return on equity to the owners. Eventually if the downturn continues, the business will make a loss, and no longer be able to cover the interest on its debts or the debt repayments. The return on equity will become negative exacerbated by the high level of financial leverage, and the business will fail. For this reason, the higher the financial leverage, the more risky the business is perceived to be.
When producing financial projections thought needs to be given to the capital structure and the effect of financial leverage on the business. The aim is to provide a decent return on equity while keeping the risk to a minimum.
Although levels of acceptable financial leverage vary from industry to industry, a bank would not normally want to lend more than the owners have invested, which gives a 100% or 1:1 financial leverage ratio. In the financial projections template, the financial leverage is indicated on the financial ratios page under the leverage ratios heading as the debt equity ratio.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.