In running and developing a business, capital is one of the main foundations. Business capital can come from two primary sources: equity and leverage. Currently, most companies are more likely to use it because it is more multifunctional and profitable, so the owner can use equity for other purposes within the company. Actually, what is leverage?
Table of Contents
- What is Leverage?
- Leverage Ratio
- Types of Leverage
- How Leverage Works
- Risk of Leverage
What is Leverage?
Leverage refers to the amount of debt a firm uses to finance assets. In addition, leverage or liability is also often defined as the amount of debt used to finance or purchase company assets to maximize business profits or return on investment (ROI). Companies use the funds from debt to develop and meet business needs. That way, the results obtained can be much more excellent than relying solely on their limited capital.
Leverage is different from the equity in business capital. If liability is debt, then equity is the capital owned by the businessman. The two are the opposite of each other. Increasing equity can reduce the use of liability and vice versa.
The leverage ratio is the ratio of the amount of debt in the company compared to the company’s total assets, which also means the company’s ability to meet its obligations with the number of its assets. There are several ratios to measure the leverage formula, namely:
Debt to Total Asset Ratio
The ratio of debt to total assets (DAR), commonly called the debt ratio, shows how much of the total assets use debt for shopping.
DAR = Total Debt : Total Assets
The lower the DAR value, the better the security level of the funds, and the more secure the recording of financial transactions. This is because the debt ratio explains the extent to which assets can cover the debt.
Debt to Equity Ratio
This debt-to-equity ratio (D/R) shows the relationship between long-term debt and the company’s total capital.
D/R = Total Liabilities : Total Shareholders Equity
The lower the DER value, the better the company’s financial security level, and vice versa.
Long-term Debt to Equity Ratio
The long-term debt-to-equity ratio’s purpose is to measure the portion of own capital that is collateral for long-term debt.
LTDER = Long-Term Debt : Equity
Times Interest Earned
This interest-paying ratio helps measure how much operating profit can pay interest on the debt. After counting Times Interest Earned (TIE), the company will know how much net profit it has also referred to as Interest Coverage Ratio.
TIE = Operating Profit(+Depreciation) : Interest on Long-Term
Tangible Assets Debt Coverage
The company also needs to calculate how many fixed assets it can use to guarantee its long-term debt or Tangible Assets Debt Coverage (TAD).
TAD Coverage = (Total Assets + Tangible + Current Debt): LongTerm Debt
Types of Leverage
There are three types of leverage that have different functions and uses, namely:
Financial leverage is a type of loan to maximize returns on securities as well as profits from company shares. To determine the amount of financial leverage, we can look at the debt-to-equity ratio of the company. The higher the ratio or percentage, will increase the risk of bankruptcy.
Operating leverage is the company’s ability to use operating costs, which are fixed costs, intending to continue to generate sales profits against business operating profits. If the company’s fixed costs are higher than the variable costs, then the company has high operating leverage. This type of liability also shows the relationship between changes in sales and expenses in fixed operating income.
This type of liability is a combination of the two types mentioned above of business debt. Combined leverage benefits not only the business owner but also the company’s shareholders.
How Leverage Works
Leverage has a way of working that is similar to debt in general. Suppose a business owner needs to buy an asset to support business operations but does not have enough money to purchase it. At this time, the company can use liability. Companies need to calculate how much they have to spend to pay liability because companies must pay these installments every month to the bank with a precise maturity date.
Furthermore, after the asset is purchased, the company will work hard to generate profits from the assets it already owns. The company uses the profits it regularly generates for debt payments.
Risk of Leverage
No matter how the company uses leverage to run the company, debt is still a debt with risks. Here we summarize some of the risks that a business owner should know before deciding to take on liability, among them:
Higher the leverage, the less profit
It is important to stress that the advantages do not outweigh the level of leverage. Therefore the company should adopt the amount of liability right and consider it carefully from the start. So the company can take advantage of liability properly.
Higher the leverage, the higher the psychological burden
Suppose the company forces itself to take a high amount of liability, sometimes even excessive. In that case, it can become a burden for the business owner and the company because calculating loan repayments is the company’s primary responsibility.
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Leverage is the use of debt or loan funds to increase returns or profits in a business or investment. These funds can be used to improve the company’s limited equity to develop and run the company. Even so, taking liability must be based on careful calculations. Because if we take a capital loan without calculating a proportional amount, it will have a burdensome return risk. Hashmicro Accounting System can help your company in managing all financial aspects. Starting from income, cash balances, accounts receivable, accounts payable, budget management, making profit and loss reports, cash flows, balance sheets, changes in capital, and more in seconds with one integrated system. Schedule a free demo now to experience the transformational power it brings to your operations.