Even if they are available many sources of funds, not all of them are always equally appropriate to the business financing. Each of these types of financial resources has its conditions, otherwise the recipient is obliged to meet its commitments concerning debt repayment and are otherwise available for the purpose of profitable business.
Most of entrepreneurs and businessman initially often throughout their entire existence confine their financial strategy to bank loans. No matter if stages of business needs long term or short term financial needs. Bank financing be considered as at least complicated, the least risky and easy. In the many aspects and for lot of cases it is true. But mostly the reverse is true. Other financial providers than bank mostly share the risk of business with the recipient of funds. The Bank does not directly make it.
Debt versus equity.
Company financing can be arranged from two fundamentally different types of financial sources:
- Own resources (equity capital, including retained earnings)
- Money borrowed from foreign sources-debt financing
As for own resources, they are the safest in business risk. If we do not produce profits, then the owner and, where appropriate, the burly shareholders simply do not get their dividend. They don 't have to be enthusiastic, but they usually won 't be able to claim money.
This is the money lent for the purpose of doing business from outside sources. They carry a risk for entrepreneurs that they will not be able to return them in the event of a non-profit, so they also pose a risk to those who lend such sources as they may not get them back for the same reason. The financial resources are so remunerated with regard to the level of risk. The big impact on business also has the ratio between equity and foreign resources we put into business. The big impact on business also has the ratio between equity and foreign resources we put into business. It's called leverage. If the leverage is "strong" (there is more foreign resources in the business than its own), the business can accelerate and bring great profits to the owner and shareholders, or vice versa to destroy the business.
How does leverage work?
I'm sure you've heard from different parties that equity capital is more expensive and riskier than foreign capital. It simply sounds, but it evokes questions of type: The foreign capital does carry debts, and it worsens the liquidity and solvency of the company. For this reason, own resources cannot be riskier and more expensive than foreigners.
Let's try to explain:
Foreign capital is cheaper due to the functioning of the financial leverage principle and also due to the effect of the tax shield (interest on loans is deducted from profits before taxes). Cheaper in this submission means that it is more profitable and that using foreign capital we can achieve a higher return on equity.
The profitability of equity is based on three basic components:
- Profit margin
- Asset turnover
- Financial Leverage
So, if leverage is positive, our business will grow and be more efficient and profitable. As far as the tax shield is concerned, it only works as supported. The fact is that the “loan capital” generate so called costs interest that is deductible from the tax base and thus reduce tax.
Consider our example:
The table below shows 4 cases as the leverage in the company results is reflected. For simplicity, suppose we need to create an operating profit of 400 € (the units themselves) have a share capital of 4 800 €.
1. Financial leverage = 0. Only own invested resources are used for business. Here's the leverage = 0. We do not use any foreign resources, we do not pay any interest on loans.
2. 2.-4. Case used different level of financial leverage. Here you notice that despite all that we have to pay interest on credit, the profitability of shareholding capital grows from 6.7% (leverage = 0) to 14.7% at very high leverage = 1:3. This is where we put only 30% of our own resources into business and others was lent from friends or family, bank, or somewhere in the financial market.
You could say, fine, the less of my own money I put into the business, the more I can borrow, the more profitable my business will be.
This is the way it finally follows from the example above. But we must make sure that leverage is working to our advantage. In other words, that we can generate at least income we've planned.
But what if we are not able to reach expected income? And the leverage will start to act against us?
When does leverage work against us?
A very important factor is the fact to ensure the anticipated revenues. If these fall below a certain level, we will not be able to pay interest on the loans granted. Interest must still be paid in the same amount, even if we do not have enough income.
Suppose we earn revenues instead of 400€ only 120€.
From the following table is evident, that while in 1st case when we do not use financial leverage, we still generate profit from the deposited capital of 2%, while for other variants of the financing of our business this no longer applies.
If we used funding with leverage 1:2, in this case we are only working to pay interest of loans. This is definitely not the goal of our business.
In the other two cases we already lose and made serious troubles many times leading till to our bankruptcy.
And this is another problem when we use financial leverage in business. If the company is already at this stage, the demands of the owners of the company are satisfied as last. After satisfying the state, banks, employees, suppliers and other creditors of the company. This you should be keep in mind, when plan to use financial leverage.
To the leverage operate in our favour, this rule must apply:
Return on equity > profitability of assets X (1 – Income tax rate)
The profitability of assets > The rate of cost interest
But let's look at a concrete example and the comparison of leverage:
1. Case – We achieve anticipated income – 400€:
2. case – Our revenues fell to 3 000 CZK.
Here it is clear that if we used the smallest leverage – 1:1, the equity return is equal to "0". In fact, we only work to amortisation interest on the loan.
Do you plan to take credit for business? Try to calculate yourself if it pays off.