Financial leverage is a financial indicator to measure the financial risk of a company. The following Benefits and risks of using financial leverage below are;
Financial risk refers to the additional risks borne by equity capital arising from the use of debt capital by an enterprise in the event of uncertain future returns. If the business condition of the enterprise is in good condition so that the profit margin before interest and tax of the enterprise is greater than the interest rate on the debt, the benefit of financial leverage will be obtained; on the contrary, the loss of financial leverage will be obtained, and even lead to bankruptcy. This uncertainty is the financial risk borne by the enterprise using its liabilities.
The level of financial leverage coefficient is the main determinant of the size of an enterprise's financial risk. Financial leverage can increase the value of an enterprise and its equity capital. At the same time, there are also shortcomings. Excessive financial leverage can lead to an increase in the bankruptcy rate of an enterprise and the cost of bankruptcy.
Factors affecting the risks and benefits of financial leverage
Pre-tax profit margin
On the premise that other factors remain unchanged, the EBIT profit margin is inversely proportional to the financial leverage coefficient. The higher the former, the smaller the latter; on the contrary, the lower the former, the greater the latter.
Capital structure
The ratio of liabilities to total capital is the debt ratio, which is usually used to indicate the proportion of corporate liabilities to all funds. On the premise that the EBIT profit margin and the debt interest rate are not the same, the debt ratio is proportional to the financial leverage coefficient. The higher the former, the greater the latter; on the contrary, the lower the former, the smaller the latter.
Changes in interest rates
On the premise that the capital structure and the EBIT interest rate are certain, the interest rate is proportional to the financial leverage system. The higher the former, the greater the latter. In the general environment of financial markets, the level of interest rates directly determines the cost of borrowing funds for enterprises. When tight fiscal and monetary policies are implemented, that is, the “double tightening” policy, the money supply decreases, and the loan interest rate increases.
When enterprises raise funds at this time, their capital costs will inevitably increase. Therefore, enterprises have to bear relatively large financing risks when implementing the “double tightening” policy. On the contrary, when the country is implementing an expansionary fiscal policy and a loose monetary policy, the “double pine” policy, the risks faced by enterprises when repaying debts are relatively small.
The degree of competition in the industry in which the enterprise is located
When considering the use of financial leverage, it is necessary to conduct an effective analysis of the intensity of market competition for products in its industry. For listed companies in some industries, competition in their markets is fierce and price wars are frequent. To defeat opponents and reduce the product profit margins and operating cash flows of similar products in the industry, competitors with relatively low debt levels and financial leverage often take the initiative to launch price wars and marketing wars when the debt levels of companies in the industry are relatively high.
After the impact of a long-term price war, companies with high debt will experience a breakdown in capital flow and fall into a financial crisis, resulting in a significant decline in the competitiveness of enterprises, and eventually forced to withdraw from the market. Therefore, to reduce the risk of enterprises and ensure the long-term stable development of enterprises, enterprises in the industry, the more fierce the product market competition, the more they will choose low financial leverage. It can be seen that small financial leverage plays a vital role in making enterprises invincible in the fierce competition of enterprises.
Countermeasures to avoid financial risks
According to the factors that affect financial risks and returns, when an enterprise has financial risks, the enterprise should take some favorable measures to reduce the adverse effects of financial leverage on the enterprise.
Enhance corporate profitability and increase EBIT profit margins
Increasing the profitability of an enterprise is the fundamental way to reduce the financial risks of income and expenditure, and use leverage correctly to realize the benefits of financial leverage. Therefore, enterprises should conscientiously implement the national industrial policy, do a good job in adjusting the product structure, conform to the trend of market development, and continuously develop market-oriented new products; improve the incentive mechanism, development mechanism, and sales mechanism: implement business diversification and commission the proportion of enterprises in the competitive market.
Optimization of capital structure
An enterprise can optimize its capital structure from two aspects. On the one hand, it can optimize its capital structure statically, so that the proportion of the enterprise's capital increases, thereby reducing the overall debt risk; on the other hand, it dynamically adjusts the asset profit margin and the debt interest rate to increase the asset profit margin, and the debt ratio is automatically adjusted accordingly, the financial leverage coefficient increases, and the capital profit margin increases. When analyzing the optimal debt size, the company's future long-term development income should be taken as the premise, fully considering financial risks, financial leverage, the degree of competition in the industry, and other factors, to determine the optimal debt size of the company.
Analyze future interest rate trends through current national policies
Changes in interest rates will have a direct impact on the interest on liabilities, which will also have an impact on financial prevention and financial risks. It can be seen that enterprises must analyze the trend of future interest rates and grasp the trend of their future development, to formulate effective debt management policies to deal with future interest rate fluctuations. For example, when interest rates transition from high to low, the raising of funds for interest-bearing liabilities should be reduced. If there are funds that must be raised, the floating interest rate method of interest calculation should be adopted to raise funds to reduce the company's financial risks.
On the contrary, when the interest rate rises from low to high, the fixed interest rate method of interest calculation should be adopted to actively raise long-term funds. It is expected that China's inflation rate will remain high in the short term and interest rates will continue to rise. Therefore, for companies that are highly dependent on loans, such as real estate, roads, steel, automobiles, and other industries, it is necessary to borrow as little as possible. Interest-bearing liabilities, adopt other methods of financing and reduce financial leverage.
According to the degree of market competition in the industry's products, financial risks are expected
In my country, the company's industry has a high degree of product market competition and a high proportion of liabilities. When an enterprise is operating in debt, its funds are usually relatively tight. In this case, the enterprise will borrow a lot of debt for the business activities it has already carried out, regardless of the risk of using debt funds. This initiative will expose enterprises to a huge risk of bankruptcy, which will lead to the development of poor financial conditions for enterprises, especially in the case of the financial crisis sweeping the world, higher financial leverage hurts enterprises and brings greater risks to corporate finances.
Therefore, if the company's future operating conditions are expected to be poor and the product market competition in the company's industry is high, the company should adopt a conservative financial policy, that is, to reduce liabilities, reduce debt ratios, and reduce financial leverage. Conversely, if the economy is expected to improve in the future and the degree of product market competition in the company's industry is low, more debt financing should be selected.
Develop a financial risk prevention mechanism
In a highly competitive market economy environment, financial risks exist objectively. Enterprises should improve their ability to adapt and adapt to changes in the financial management environment, formulate an efficient management mechanism for the company's financial management, improve the rules and regulations of financial management, and at the same time, set up a financial early warning system to improve the risk awareness of senior financial managers.
In real financial work, one of the important reasons for financial risks is the weak risk awareness of senior financial managers. They subjectively believe that the way to control financial risks is to do a good job in the management of funds, and risk awareness is weak. Therefore, if an enterprise wants to ensure the healthy operation of its operations and maximize the value of the enterprise, it should start by raising the risk awareness of managers.
Summary
Using financial leverage, the interest generated by the debt-financed by the enterprise is tax deductible, so that the cost of debt capital is lower than the cost of equity capital, which reduces the weighted average cost of capital of the enterprise itself, thereby increasing the value of the enterprise. It can be seen that the behavior of enterprises is more aggressive in the fierce competition for product duration than when there is no debt.
However, when making capital structure decisions, an enterprise cannot only consider the interest tax deduction benefits of debt and the increase in the return on equity capital brought about by financial leverage. It should also fully consider the bankruptcy risks that financial leverage may bring to the enterprise, and how can the enterprise make itself occupy a competitive advantage in the fierce competition in the product market of the same industry and realize the sustainable development of the enterprise.
The high risk of bankruptcy brought by high financial leverage to an enterprise will increase the cost of debt and equity capital of an enterprise. The increase in cost will lead to insufficient financial affordability of the enterprise, which greatly weakens the investment ability of the enterprise, thus forcing the enterprise to reduce capital investment, and in more serious cases, it will even withdraw from the market competition for products in the same industry.
Enterprises should carefully analyze the changing macro environment according to their circumstances, especially the national industrial policies, industry policies, relevant laws and regulations, market changes and changes in the economic situation, and other factors. Conduct a full analysis and research, grasp its changing trends and laws, adjust financial management methods promptly, improve the company's adaptability and resilience, and reduce the financial risks caused by some unnecessary factors. When conducting financing and investment economic activities, conduct a scientific feasibility analysis of the project.
In the fierce competition in the product market of the same industry, the fluctuations and changes of multiple factors have caused the actual implementation results of the enterprise to deviate from the expected results. It can be seen how important it is to establish a sense of risk prevention and improve the risk prevention mechanism. The financial department of an enterprise shall extensively collect information on all aspects of the competitive market of products in the same industry, make scientific risk forecasts promptly, and formulate a set of risk aversion measures in line with the company's financial management to prevent and spread risks.