Leverage: On the other side of debt

When I think of Filipino small and medium enterprises entrepreneurs, my father is the first person that comes to mind. One night over dinner, he mentioned that an acquaintance of his had offered to finance his latest venture with debt, to which he refused. “Never spend money that you don’t have, or that isn’t yours,” he told me. I was surprised to find out that in his many years of running his businesses, he never once used debt to finance them. That night, we had a lengthy discussion on financial leverage, a term that he had not heard of until then.

Leverage is a measure of the use of fixed costs relative to variable ones, and so financial leverage answers the question: “How much of your business is financed with debt (your fixed costs) relative to equity (the variable)?” The term “leverage” is used because your fixed costs give you an opportunity, or an advantage, to amplify your returns (or, on the downside, your losses). When we talk about returns in this case, we talk about our return on equity or ROE. It’s a financial ratio computed by dividing your period’s net income by the same period’s average shareholder’s equity, and what it basically tells us is, of your own equity invested, how much were you able to profit from it? Take for example a business that needs a million pesos of capital with an earnings-before-tax (EBT) of P150,000. With an equity investment of P1 million, you get a net income (ignoring tax calculations) of P150,000, and an ROE of 15 percent. Now introduce debt financing at an interest rate of 6 percent (keeping the net income calculations in the background): with a debt-to-capital ratio of 20 percent (P200,000 of capital from debt and P800,000 from equity), your net income goes down to P138,000, but your ROE goes up to 17 percent. With a debt-to-capital ratio of 50 pecent, net income is P120,000 and ROE is 24 percent. And with a debt-to-capital ratio of 80 percent, net income is P102,000, while ROE is 51 percent. The gist is this: your nominal earnings in the form of net income decreases because of the added interest expense, but your ROE increases because you’re using less of your own money to gain those profits.