What is the leverage effect?
As an entrepreneur, you invest capital in your company with the intention of earning money from it. We express the return in terms of the “return on equity”. Example: You have invested 100,000 guilders and make a profit of 20,000 euros in a year. Your return on equity is then 20%.
Investing money costs money, namely interest. Whether you use other people’s money (interest costs) or your own money (loss of interest). It is therefore not unreasonable to assume that we strive to keep the return on capital above the market interest rate. People sometimes jokingly say: “otherwise you are better off taking your money to the bank than investing it in your company.”
The market interest rate as a return percentage is therefore the tipping point for the responsible use of borrowed capital (=money from the bank or a financier) in the enterprise. In fact, if the return on total capital (=debt plus equity) is higher than the market interest rate, the return on your equity exceeds the return on total capital.
In other words: in that case, you can earn more if you have raised debt capital than if you have used exclusively equity capital.
We call this the leverage effect.
We will clarify this using an example. Assume the interest rate is 8%, your return on total capital is 10%, and the total capital is 200,000 euros. The return on total capital is therefore 20,000 euros.
a. If equity amounts to 200,000 and debt is 0: bank interest 0, so the return on equity is 10%.
b. If equity amounts to 100,000 and debt is 100,000; bank interest of 8% on 100,000 is 8,000; return on equity 12,000 guilders = 12%
c. If equity amounts to 50,000 and debt 150,000; bank interest of 8% on 150,000 is 12,000; return on equity 8,000 = 16%
In other words: you earn money with the debt. And, in this case, lower solvency (=equity/total assets) leads to a better result than higher solvency. Low solvency is therefore not always unfavorable.
The situation is entirely different if your total return is below the market interest rate. Then the leverage effect works in the opposite direction. We will also provide an example of this.
Assume the interest rate is 8%, your return on total assets is 6%, and total assets are 200,000 euros. The return on total assets is therefore 12,000 euros. a. If equity amounts to 200,000 and debt is 0: bank interest 0, so return on equity is 6%
b. If equity amounts to 100,000 and debt is 100,000; bank interest of 8% on 100,000 is 8,000; return on equity of 4,000 is 4%
c. If equity amounts to 50,000 and debt is 150,000
