Leverage Effect

The leverage effect describes the impact of using debt capital on a company's return on equity. It occurs when a company can increase its return on equity by taking on debt (borrowed capital) as long as the return on the capital employed is higher than the cost of the borrowed capital. Put simply, the leverage effect enables a company to achieve a higher return on the equity invested by using borrowed money. However, it should be noted that a higher level of debt also increases the risk, especially if the income does not exceed the cost of debt.

Leverage effect explained simply

The leverage effect means that a company can make more profit by taking out loans (borrowed capital) than if it only used its own money (equity). If the interest on the loan is lower than the profit that the company generates with the borrowed money, the profit for the equity providers increases. Put simply, debt allows a company to make more of its own money, but it also makes it riskier because it has to repay the debt.

Prerequisites for the leverage effect

Certain conditions must be met for the leverage effect to occur:

1. Positive difference between return on total capital and cost of debt: the return a company earns by investing its total capital (equity plus debt) must be higher than the cost of debt (interest).
2. Ability to raise debt capital: The company must be in a position to raise debt capital. This depends on the company's creditworthiness and the conditions on the credit markets.
3. Stable or growing earnings situation: The company should generate stable or growing earnings in order to be able to service the interest and repayments of the debt capital.
4. Controlled indebtedness: The level of debt must remain within a controllable range in order to minimize the risk of over-indebtedness and associated financial difficulties.
5. Efficient use of capital: The borrowed capital must be used efficiently to finance investments that actually generate higher returns than the borrowing costs.

If these conditions are met, the leverage effect can have a positive impact and increase a company's return on equity.

The leverage effect is worthwhile under certain conditions. Here are the main factors that ensure that the use of debt capital to increase the return on equity makes sense:

1. High return on investment (ROI): The return on total invested capital (equity and debt capital) must be higher than the cost of debt capital (interest). The greater the difference, the greater the positive effect on the return on equity.
2. Favorable borrowing costs: The interest on the borrowed capital should be low. Low borrowing costs increase the probability that the total return on capital will be higher.
3. Stable earnings situation: The company should be able to generate stable and predictable earnings. A constant cash flow ensures that interest and principal payments can be made without difficulty.
4. Good risk management: The company should have an effective risk management system in place to manage the additional risks associated with higher debt. This includes measures to hedge against interest rate changes and economic downturns.
5. Growth opportunities: If the company can use debt to invest in growth projects that generate higher returns than would be possible with equity alone, the leverage effect is particularly worthwhile.
6. Tax advantages: In many countries, interest expenses are tax deductible, which can reduce the effective cost of debt capital and therefore increase the leverage effect.
7. Good rating/credit rating: A good credit rating enables the company to borrow at more favorable conditions, which improves the leverage effect.

Under these conditions, the leverage effect can significantly increase a company's return on equity and thus make the use of debt capital attractive.

Financial leverage

• Definition: Refers to the use of borrowed capital to finance investments in order to increase the return on equity.
• Example: A company takes out a loan to invest in new machinery. If the return on this investment is higher than the cost of the loan, the return on equity increases.

Operational leverage

• Definition: Refers to the share of fixed costs in a company's total costs. High operational leverage means that a large proportion of costs are fixed.
• Example: A company with high fixed costs and low variable costs can increase profits disproportionately by increasing sales, as the fixed costs remain constant.

Combined leverage

• Definition: A combination of financial and operating leverage. It takes into account both the use of borrowed capital and the proportion of fixed costs.
• Example: A company uses both borrowed capital for investments and a high proportion of fixed costs in production. The leverage effect on the return on equity is increased by both factors.

Operating leverage

• Definition: Describes the influence of the change in sales volume on the operating result (EBIT). High operating leverage leads to large fluctuations in EBIT in response to changes in sales.
• Example: A company with high fixed costs and rising sales will experience a disproportionate increase in operating profit.

The leverage effect works through the leverage effect of debt capital on a company's return on equity. Here is a simplified explanation of how it works:

1. Capital structure: A company has two ways to raise capital: equity (its own money or investments from owners) and debt (borrowed money, e.g., loans).
2. Investment: The company invests this capital in projects or assets that generate returns.
3. Return on investment (ROI): The return that the company achieves on its total capital employed (equity and debt) is the return on investment (ROI).
4. Cost of debt: The company pays interest on the borrowed money (debt). These interest costs are the cost of debt.
5. Comparison of ROI and borrowing costs: If the ROI is higher than the borrowing costs, the company generates additional profit by using borrowed capital.
6. Calculation of return on equity (ROE): The return on equity (ROE) is calculated by dividing the remaining profit, after deducting interest costs, by the equity.

Illustration: The leverage effect in direct comparison

To understand how the leverage effect works, let's look at two identical companies that differ only in their financing structure. Both companies generate a total return on investment (ROI) of 10% with their invested capital.

For leverage to have a positive effect, the following conditions must be met:

• Return on investment > interest on debt: The company must earn more (ROI) with the borrowed money than it has to pay in interest (i) to the bank.
• Constant ROI: We assume that the additional capital raised does not change operational efficiency.

The aim of the comparison: The following shows how the return on equity (ROE) – i.e., the return on your own invested capital – changes as soon as you add debt capital as "leverage."

Although the leverage effect can increase the return on equity, there are also important points of criticism and limitations that must be taken into account:

Criticism of the leverage effect

1. Distortion of the financial situation: The use of debt capital can distort the actual financial stability of a company, as the higher profits are based on an increased debt burden.
2. Short-term profits: The leverage effect can increase the short-term Rate of Return without ensuring long-term sustainability. This can lead to risky behavior and short-term thinking.

Limits of the leverage effect

1. Limited access to debt capital: Not all companies have equal access to favorable credit terms. Smaller or less established companies may find it difficult to raise sufficient debt capital on favorable terms.
2. Decreasing marginal utility: As debt increases, the positive effect of leverage on return on equity decreases as risks and costs also increase.
3. Economic conditions: The leverage effect only works under certain economic conditions, such as stable economic growth and low interest rates. Economic uncertainties or crises can have a negative impact on the effect.