Financial Leverage Simplified

Financial leverage is hugely utilized in corporate finance. But today, we are simplifying it by providing example of a sole trade. We know that in sole trade all capital is of one person and his aim is to maximize it. With financial leverage he can do it.

Financial leverage is tool to use own capital with debt for doing business. Following is the example which will simplify this finance term.

Mr. A has own capital of Rs. 5,00,000 and he bought a machine with his Rs. 5,00,000. Mr. A is not using financial leverage because he is using his own money for trading.

Mr. B has own capital of Rs. 5,00,000 and he took the loan of Rs. 10,00,000 @ 5% fixed interest. Now, he has Rs. 1500000 and he bought top quality machine with this Rs. 15,00,000.

If the machines owned by Mr A and Mr. B increase in value by 10% and are then sold, Mr. A will have a Rs. 50,000 profit on his own capital Rs. 500,000, a 10% return. Mr. A’s land will sell for Rs. 16,50,000 and will result in a gain of Rs. 150,000.

Now if we calculate the Mr. B's return on his own capital, it will be very high.

Mr. B's Return on his own capital = Rs. 150000/ Rs. 500000 X 100 = 30%, if B has to pay interest of 5% on debt, then he will gain net = Rs. 150000 - 50,000 = 1,00,000

which will be the 20% of his own capital. Mr. A who is not using financial leverage, is gaining just 10% return.

Suppose if machine's value will increase by 20% and sell, then Mr. B's Return on his own capital  after deducting 5% fixed interest, will be = Rs. 300,000 profit from sale of machine - Rs. 50000 interest
 = Rs. 250000

Or = 250000/500000 X 100 = 50% which is 30% more than Mr. A's profit.

It means when assets inflate in value financial leverage works well.  But when assets decline in value the use of leverage works against you.

Related : Leverage Effect on ROE






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Accounting Education: Financial Leverage Simplified
Financial Leverage Simplified
Accounting Education
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