Leverage Effect

The leverage effect, a term frequently used in the fields of finance and investment, plays a central role in the modern economy. Its importance is evident not only in corporate finance, but also in personal investment behavior. In this article, we will explore the mechanisms and impact of leverage, highlight its benefits and risks, and explain why it is highly relevant to both investors and companies. By gaining a deeper understanding of this effect, more informed decisions can be made and potential pitfalls avoided.

Leverage effect definition: What is the 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:

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).
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.
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.
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.
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.

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Leverage Effect: Advantages and Disadvantages

This table summarizes the main advantages and disadvantages of leverage and helps to better understand its impact on a company's financial health.

Advantages	Disadvantages
Increase in return on equity: The use of debt capital can increase the return on equity if the total return on capital is higher than the cost of debt.	Increased financial risk: A higher debt ratio increases the risk that the company will not be able to meet its financial obligations.
More efficient use of capital: Companies can make larger investments without raising additional equity.	Interest rate risk: Changes in interest rates can increase the cost of debt, which has a negative impact on the Rate of Return.
Growth and expansion: Debt capital enables faster growth and the development of new business opportunities.	Liquidity risk: Regular interest and principal payments can place a heavy burden on the company's liquidity.
Tax benefits: Interest expenses for debt capital are tax deductible in many countries, which lowers the effective costs.	Excessive debt: Too much debt can lead to over-indebtedness, where debt is higher than equity, which jeopardizes financial stability.

When is the leverage effect worthwhile?

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:

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.
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.
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.
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.
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.
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.
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.

Leverage effect calculation

To calculate the leverage effect, the formula for return on equity must be used.

Leverage effect formula

The following formula is used to calculate the leverage effect:

The abbreviations stand for:

ROE: Return on equity
ROI: Return on investment
Borrowing costs: Interest rate of the borrowed capital
Borrowed capital: Amount of borrowed capital
Equity: Amount of equity capital employed

Leverage effect example

Assume a company has the following values:

ROI: 12%
Borrowing costs: 5%
Borrowed capital: € 200,000
Equity: € 100,000

The return on equity (ROE) is calculated as follows:

Determine the leverage value:

Borrowed capital / Equity = 200,000 / 100,000 = 2

Calculation of the additional profit due to the leverage effect:

(ROI - Borrowing costs) x Borrowed capital / Equity = (12% - 5%) x 2 = 7% x 2 = 14%

Calculation of the return on equity (ROE):

ROE = ROI + 14% = 12% + 14% = 26%

The return on equity (ROE) is 26%, which shows that the use of debt capital has significantly increased the profit for equity providers.

What is Rate of Return in this context? How exactly does the ROE formula work?

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Important terms relating to
the leverage effect

terms relating to the leverage effect

Term	Definition
Leverage effect	The leverage effect describes the effect of debt capital on a company's return on equity.
Return on equity (ROE)	The return that a company achieves on its equity.
Return on investment (ROI)	The return that a company achieves on its total invested capital (equity and debt).
Borrowing costs	The costs (interest) that a company has to pay to borrow capital.
Borrowed capital	Capital that a company borrows from external lenders (e.g. banks).
Equity	Capital contributed by the owners of a company.
Leverage	The effect that the use of debt capital can increase the return on equity.
Interest rate risk	The risk that changing interest rates will increase the cost of debt capital and thus have a negative impact on the Rate of Return.
Liquidity risk	The risk that regular interest and principal payments will place a heavy burden on a company's liquidity.
Over-indebtedness	A situation in which a company's debt is higher than its equity, which jeopardizes its financial stability.

This table provides an overview of the key terms in connection with the leverage effect and their definitions.

How does the leverage effect work?

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:

Capital structure: a company has two ways to raise capital: Equity (the owners' own money or investments) and debt (borrowed money, such as loans).
Investment: The company invests this capital in projects or assets that generate returns.
Return on investment (ROI): The return that the company earns on the total capital invested (equity and borrowed capital) is the return on investment (ROI).
Borrowing costs: The company pays interest on the borrowed money (borrowed capital). These interest costs are the borrowing costs.
Comparison of ROI and borrowing costs: If the ROI is higher than the borrowing costs, the company makes an additional profit through the use of borrowed capital.
Calculating the return on equity (ROE): The return on equity (ROE) is calculated by dividing the remaining profit, after deducting interest costs, by the equity.

Here is an example to illustrate this:

With borrowed capital:

Equity: € 100,000
Borrowed capital: € 100,000 (with 5% interest)
Total capital: € 200,000
Total return on investment (ROI): 10%
Profit: € 20,000
Interest costs: € 5,000
Profit after interest: € 15,000

Return on equity (ROE): € 15,000 / € 100,000 = 15%

Without borrowed capital:

Equity: € 100,000
Return on investment (ROI): 10%
Profit: € 10,000

Return on equity (ROE): € 10,000 / € 100,000 = 10%

Conclusion:

In this example, the return on equity increases from 10% to 15% because the return on total capital (10%) is higher than the cost of debt (5%). This shows the leverage effect of debt capital on the return on equity.

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The types of leverage effect

The leverage effect can be categorized into different types depending on which aspect of corporate finance it relates to. Here are the main types of leverage:

Overview: Types of leverage effect

The following diagram shows an overview of the types of leverage effect.

Explanation: Types of the leverage effect

The various types of leverage are summarized below, together with their definitions and an example to illustrate them.

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.

What exactlyis an EBIT in this context?

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Criticism and limits of the leverage effect

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

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.
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

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.
Decreasing marginal utility: As debt increases, the positive effect of leverage on return on equity decreases as risks and costs also increase.
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.

Table for illustration

This table summarizes the main criticisms and limitations of the leverage effect and shows why a cautious and well-considered use of debt capital is crucial.

Category	Points of Criticism	Limits
Financial position	Distortion of financial position	Limited access to debt capital
Sustainability	Short-term profits	Diminishing marginal utility
Stability		Economic conditions

FAQ

What is a good leverage effect?

A good leverage effect is achieved when the company can increase its return on equity by using debt capital because the return on total capital is higher than the cost of debt capital without taking on excessive financial risk.

Why do companies use the leverage effect?

Companies use the leverage effect to increase their return on equity and to make larger investments that they could not finance with equity alone.

When is the leverage effect negative?

The leverage effect is negative if the total return on capital is lower than the cost of debt.

When is the leverage effect zero?

The leverage effect is zero if the return on total capital employed corresponds exactly to the cost of debt capital.

What is leverage risk?

Leverage risk is the risk that the financial stability of a company is jeopardized by the use of borrowed capital, particularly if the borrowing costs exceed the return on total capital.