Each enterprise is required to conduct research on its core business. This allows you to organize available resources as efficiently as possible. Therefore, sources of funds are constantly monitored.
The ratio of borrowed and equity funds allows you to evaluate the correctness of the structure. The indicator formula is necessarily used by analysts during the research. Based on the data obtained, conclusions are drawn about the financial stability of the enterprise, and measures are developed to improve profitability and sustainability.
Passive
The ratio of borrowed and equity funds, the formula of which will be presented below, is calculated according to the liabilities of the enterprise’s balance sheet. It displays all financial sources that participate in the company's activities.
The balance sheet liability consists of equity, as well as long-term and short-term borrowed funds. Their ratio should be such that the organization can generate the greatest profit while using the least amount of resources.
The company’s own sources of property formation show the level of its stability. But by using it, an enterprise can increase its net profit and operating profitability. Therefore, a certain part of the company’s capital formation sources should consist of investor funds.
Equity
The financial independence of an organization lies in the organization of its production activities at the expense of the owners. These are those that are fully owned by the company. They are not subject to return to investors, so they are considered free.
The company's own funds are formed from several sources. First of all, this is the authorized capital. The organization forms this fund during the process of its creation. Its size is established by law. The founder or founders contribute a certain part of their property to the authorized capital. According to their contribution, they are entitled to the same (as a percentage) amount of profit after paying taxes and other mandatory deductions.
Own capital also includes various contributions, donations, and retained earnings. And if the owners are required to contribute the authorized capital to the general fund, then other injections are optional. Having received net profit in the reporting period, the owners can decide on its full distribution among themselves. But sometimes it is more expedient to allocate all of this amount or only part of it to the development of production. This item is called retained earnings.
Borrowed capital
The debt-to-equity ratio, the formula of which will be discussed below, also takes into account paid sources of financing. They can be long-term (held by the company for more than a year) or short-term (subject to reimbursement during the operating period). These are funds that an organization borrows from investors and lenders for a fee.
At the end of the period of use, the enterprise is obliged to repay the amount of debt and pay for the use of this capital in the form of a set percentage. The use of such funds involves certain risks. But with the right approach, the use of paid sources of financing in your activities can provide a significant increase in net profit.
Calculation formula
To correctly understand the essence of analyzing the structure of a company’s balance sheet, it is necessary to consider the formula for the ratio of financial sources. It is also called the indicator of financial independence. Its value is of interest to both enterprise analysts and regulatory authorities or investors. The more equity a company has, the lower the risk of non-repayment of capital for creditors. The formula for calculating the debt/equity ratio is:
Kfz = ZS: SS * 100%, where ZS - borrowed funds, SC - own funds.
The higher this indicator, the more dependent the enterprise is on paid sources. The growth of the indicator in dynamics indicates a decrease in financial stability and an increase in risk for investors.
Financial leverage
The calculation of the financial dependence ratio in the world literature is called an indicator of financial leverage or leverage. This is one of the most important indicators of the financial condition of an organization. Together with it, capital, autonomy and financial dependence must be calculated.
Leverage calculation allows you to assess the opportunities and prospects for business development using borrowed capital. With its help, the company forms financial leverage. This allows you to significantly increase the return on your own resources.
Financial leverage is calculated using the above formula. Data for the study is taken from the balance sheet. Borrowed capital includes long-term capital and those reflected in liabilities.
Normative value
The financial independence of an organization is determined if the ratio of sources is equal to 1. This means that in the liabilities side of the balance sheet both capital items account for 50%.
For some companies, it is considered normal if this indicator increases to 2. This is especially true for large organizations. However, too much financial leverage is considered an aberration. This means that the company organizes its activities on the basis of borrowed capital. It will take a lot of time and money to pay off the debt. Therefore, investors do not want to invest their funds in such enterprises. There is a high risk of non-return of their capital.
Too high an independence coefficient indicates that the organization has lost the opportunity to increase the profitability of its property. Therefore, this analysis does not accept either too large or too small a coefficient value.
Provision of own capital
When calculating the independence of an enterprise, analysts must calculate the number of their own sources of financing in the balance sheet structure that would bring maximum profit. If an organization attracts borrowed capital, this is simply necessary. Therefore, along with calculating the provision of own funds (autonomy):
Ka = SC: VB, where VB is the balance sheet currency.
Its standard value must be no less than 0.5. The optimal indicator for most enterprises is 0.7. Western enterprises operate with a minimum autonomy coefficient of 0.3-0.4. It depends on the industry, as well as the ratio of current and non-current assets.
The more capital-intensive the production (the greater the share of non-current assets), the more long-term sources of financing the enterprise needs.
Cost of capital
When calculating the independence ratio, analysts, in addition to the amount of equity capital, determine the cost of borrowed funds. To do this, you need to find out the amount of interest that the company is obliged to pay to creditors at the end of the life of their property.
For this purpose, the weighted average price of borrowed capital is used. It looks like this:
Tsk = Σ (Tsk * Dk), where k is the number of paid sources of financing, Tsk is the cost of each source, Dk is the share in the total amount of capital.
Based on the data obtained, the financial risk of the enterprise is determined.
Financial leverage effect
The calculation of the risk coefficient is performed through the leverage indicator. This makes it possible to assess the effectiveness of the organization of the balance sheet structure. It quantifies a company's risk.
It includes the cost of late payment of interest and debt, as well as loss of profits due to excessive borrowing. To determine the effect of financial leverage, the following formula is used:
EFL = (1-N) * (R-P) * ZK: SK, where N is the income tax rate, P is the profitability of production activities, P is the average interest rate of paid capital.
The result is the sum of the increase in return on equity when using paid sources. If P< Р, то у компании рентабельность возрастает. Если же П >R, then it is not advisable to take out credit funds.
Having considered the ratio of borrowed and equity funds, the formula of which is mandatory used by analysts, they certainly evaluate the structure of the balance sheet. This allows you to determine the correct balance of funding sources.
DEFINITION
The ratio of equity and borrowed funds of an enterprise can characterize its financial stability, showing the amount of borrowed funds per each unit of equity capital.
The formula for the debt-to-equity ratio shows the capital structure, giving its general characteristics, including financial condition.
The formula for the debt-equity ratio is the ratio of borrowed (attracted) capital and equity capital. The debt to equity ratio is calculated using data from Form No. 1 (balance sheet).
Formula for debt-to-equity ratio
The formula for the debt to equity ratio is quite simple. It can be calculated by the ratio of the totality of debts on borrowed funds, regardless of their repayment terms, to the amount of equity capital.
The general formula for the debt to equity ratio is as follows:
K = ZK / SK
Here K is the ratio of borrowed and equity funds,
ZK – the amount of borrowed capital,
SK – the amount of equity capital.
Second version of the formula:
K = (DZ + KZ) / SK
Here DZ is the amount of long-term debt,
KZ – the amount of short-term debt.
Formula for the debt/equity ratio on the balance sheet
To calculate the ratio between equity and borrowed funds, balance sheet data is required, and the formula takes the following form:
Here K is the ratio of equity and borrowed funds,
Line 1410 – the amount of long-term financial liabilities (taken from the balance sheet),
Line 1510 – the amount of short-term financial liabilities (balance sheet),
Line 1300 – amount of equity.
What does the formula show?
The formula for the debt to equity ratio should show the optimal ratio of debt to equity. There are several coefficient values:
- The coefficient is greater than one, which indicates that borrowed capital is greater than equity capital (there is a risk of bankruptcy in some cases);
- A coefficient in the range of 0.7 – 1 shows the unstable position of the company, in which signs of its insolvency appear;
- A coefficient in the range from 0.5 to 0.7 is considered optimal; an enterprise with such a coefficient is financially stable and functions normally;
- A coefficient of less than 0.5 reflects the stable state of the company's performance, however, indicating its ineffective operation.
The ratio of borrowed and equity funds alone cannot give a complete picture of the economic activity of an enterprise. For a more accurate assessment, an analysis of other company performance ratios is also necessary.
The value of the ratio of equity and borrowed funds
The calculation of the ratio of debt and equity capital is carried out in cases where it is necessary to quickly obtain indicative data on the financial situation of the enterprise. This indicator can give a general idea of the proportions of debt and equity capital.
If own funds predominate, this reflects a good financial position, and an increase in borrowed funds may indicate probable financial instability.
The use of this coefficient is important for those people who invest their own funds in the company:
- Investors,
- Creditors,
- Banks,
- Suppliers, etc.
Examples of problem solving
EXAMPLE 1
EXAMPLE 2
| Exercise | Calculate the ratio of the company’s own and working capital if there are the following balance sheet indicators for 2 years: Line 1410 (long-term financial liabilities) 1 year – 120,000 rubles, 2nd year – 111,000 rubles. Line 1510 (short-term financial liabilities) 1 year – 15,000 rubles, 2nd year – 9,000 rubles. Line 1300 (cost of equity) 1 year – 280,000 rubles, 2 year – 210,000 rubles. |
| Solution | Formula for solving the problem: K = (line 1410 + line 1510) / line 1300 K (1 year) = (120000 + 15000) / 280000 = 0.48 K (year 2) = (111000 + 9000) / 210000 = 0.57 Conclusion. We see that the ratio is normal for both years and the debt-to-equity ratio is efficient. |
| Answer | K (1 year) = 0.48 K (2 year) = 0.57 |
Financial sustainability analysis: What is it?
Financial stability- an integral part of the overall sustainability of the enterprise, the balance of financial flows, the availability of funds that allow the organization to maintain its activities for a certain period of time, including servicing received loans and producing products.
Key indicators of the financial stability of the organization
|
Indicator |
Description of the indicator and its standard value |
|
Autonomy coefficient |
The ratio of equity to total equity. |
|
Financial leverage ratio |
The ratio of debt to equity capital. |
|
Provision ratio of own working capital |
The ratio of equity capital to current assets. |
|
The ratio of equity and long-term liabilities to total capital. |
|
|
Equity agility ratio |
The ratio of own working capital to sources of own funds. |
|
Property mobility coefficient |
The ratio of current assets to the value of total property. Characterizes the industry specifics of the organization. |
|
Working capital mobility coefficient |
The ratio of the most mobile part of working capital (cash and financial investments) to the total value of current assets. |
|
The ratio of own working capital to the amount of inventories. |
|
|
Short-term debt ratio |
The ratio of short-term debt to total debt. |
The main indicator influencing the financial stability of an organization is the share of borrowed funds. It is generally believed that if borrowed funds make up more than half of a company's funds, then this is not a very good sign for financial stability; for different industries, the normal share of borrowed funds may fluctuate: for trading companies with large turnovers it is much higher.
In addition to the above ratios, the financial stability of an enterprise reflects the liquidity of its assets in comparison with its liabilities by maturity: the current ratio and the quick ratio.
Autonomy coefficient
Autonomy coefficient(financial independence coefficient) characterizes the ratio of equity capital to the total amount of capital (assets) of the organization. The ratio shows how independent the organization is from creditors.
Capitalization ratio
Capitalization rate(capitalization ratio) is an indicator that compares the size of long-term accounts payable with total sources of long-term financing, including, in addition to long-term accounts payable, the organization's own capital. The capitalization ratio allows you to assess the adequacy of the organization's source of financing its activities in the form of equity capital.
Inventory coverage ratio
Inventory coverage ratio is an indicator of the financial stability of an organization, determining the extent to which the organization’s material reserves are covered by its own working capital.
Asset coverage ratio
Asset coverage ratio (asset coverage ratio) measures an organization's ability to pay off its debts with its existing assets. The ratio shows how much of the assets will be used to cover debts.
Investment coverage ratio
Investment coverage ratio is a financial ratio showing what part of the organization’s assets is financed from sustainable sources: equity and long-term liabilities.
Interest coverage ratio
Interest coverage ratio(interest coverage ratio, ICR) characterizes the organization’s ability to service its debt obligations. The metric compares earnings before interest and taxes (EBIT) over a specified period of time (usually one year) with interest paid on debt obligations over the same period.
The purpose of debt analysis is to study their condition, efficiency of use and determine the need for their attraction or repayment, to increase financial stability and liquidity.
Objectives of debt analysis:
Assess the amount and structure of the company’s borrowed funds;
Analyze the dynamics of borrowed funds in general and by their types;
Assess the placement of borrowed funds in the assets of the enterprise;
Identify the ratio of debt and equity funds of the enterprise.
Sources of analysis: “Balance Sheet”; “Profit and Loss Statement”, “Appendix to the Balance Sheet and Profit and Loss Statement”, analytical accounts, etc.
Based on the balance sheet, the amount of funds raised at the beginning and end of the year as a whole and by type is determined, and the structure and change in the amount and structure for the analyzed period are calculated.
When studying the funds raised, it is necessary to compare:
The growth rate of the amount of current debt with the growth of current assets;
The growth rate of debt to suppliers and contractors with changes in the volume of production and sales of products;
The amount of accounts payable and receivable;
Amounts of payments due on time with the balance of funds in the cash register and on the current accounts of the enterprise
An excess of the growth rate of the total amount of debt, compared to the growth of current assets, indicates a decrease in the level of liquidity of the enterprise and can lead to the insolvency of the enterprise as a whole.
The growth rate of production and sales of products should be higher than the growth rate of debt to suppliers and contractors; this fact will indicate an increase in the company’s own working capital and an increase in the timely ability to repay relevant payments. The size of receivables and payables must also correspond to each other, then if debtors’ obligations to the enterprise are fulfilled in a timely manner, it will be possible to timely repay debts to their creditors. The balance of funds must correspond to the amount of upcoming payments at their due dates.
Next, when studying the funds raised by the enterprise, it is necessary to determine the movement of borrowed funds by type, using the financial statements “Appendix to the Balance Sheet and Profit and Loss Statement.” Reducing the share of borrowed capital due to any of its types helps to strengthen the financial independence of the enterprise from external sources of financing. Based on these data, the amounts of borrowed funds received and repaid during the reporting period are determined, and the ratios of receipt and repayment in general and by type are calculated.
Gearing ratio shows what is the share of received borrowed funds in their total amount at the end of the year. It is determined by dividing the amount of receipts by the balance of borrowed funds at the end of the reporting period:
Debt repayment ratio shows what is the share of paid borrowed funds for the reporting period in their total amount at the beginning of the year. It is determined by dividing the amount of borrowed funds spent (used) in the reporting year by the amount of the balance of borrowed funds at the beginning of the period:
A positive phenomenon, from the point of view of the financial stability of the enterprise, is the excess of the repayment ratio compared to the borrowing ratio.
In foreign practice, the ratio of debt and equity capital is one of the most important indicators for determining the risk for creditors. In this regard, in some cases, lenders, for complete confidence in the return of funds provided on credit, require the signing of a loan agreement, which must indicate the excess of equity capital compared to borrowed capital.
Creditors and shareholders are interested in the solvency of the company, in its ability to pay interest on a timely basis and pay the face value of the obligation at the maturity date. Solvency is assessed by the following indicators:
Concentration ratio of attracted capital characterizes the share of borrowed funds in the property of the enterprise; the higher this ratio, the lower the level of financial stability of the borrower and the higher the risk of repayment of the loans provided. The recommended value of this indicator is within 0.4 - 0.5 (40% - 50%) no more.
ZK – borrowed capital (line 1400+1500)
VB – enterprise property (line 1700)
Ratio of borrowings into current assets- reflects the share of borrowed funds in the current assets of the enterprise and shows the degree of financial independence of the enterprise from borrowed funds. The lower the level of this ratio, the higher the creditworthiness of the enterprise. In practice, it is considered normal when this coefficient is 0.4 or less, i.e. borrowed capital in working capital should be no more than 40%.
TA – current assets of the enterprise (line 1200)
Coefficient of participation of raised funds in covering inventories characterizes the share of short-term debt in covering inventories, which affects the creditworthiness and solvency of the enterprise. The share of borrowed funds to cover inventories should be no more than 30%, then the enterprise will be less dependent on creditors and suppliers. With absolute financial stability, the share of own funds in inventories should be 100%.
KZK – short-term borrowed capital (line 1500)
TMZ – inventories and costs (line 1210+1220)
As a rule, in Russian enterprises the largest share of borrowed capital falls on accounts payable. In normal economic conditions, accounts payable is a necessary phenomenon and, along with accounts receivable, contributes to an increase in production volume and an increase in the efficiency of using enterprises' own capital. The art of managing accounts payable is to optimize its overall size and ensure timely repayment.
A sharp increase in accounts payable and its share in the sources of the enterprise's property may indicate an imprudent credit policy of the enterprise in relation to creditors, or an increase in sales volume, or insolvency and an increase in financial dependence on the amount of funds raised. Accounts payable may decrease, on the one hand, due to the acceleration of settlements, and on the other, due to a reduction in shipments of raw materials and supplies by suppliers. It is necessary to distinguish between normal and overdue debt. The presence of the latter creates financial difficulties, since the company will feel a lack of financial resources to purchase inventories, pay wages, etc. In addition, freezing funds in accounts payable leads to a slowdown in capital turnover. Overdue accounts payable also mean an increase in the risk of non-payment of debts and a decrease in profits. Therefore, every enterprise is interested in timely repayment of payments. Payments can be accelerated by improving calculations, timely execution of settlement documents, using the bill of exchange form of payment, etc.
Short-term debt includes: debt to suppliers and contractors; bills payable; debt to subsidiaries and dependent companies; debt to the organization's personnel; debt to state and extra-budgetary funds; debt to the budget; advances received; other creditors; debt to participants (founders) for payment of income (dividend payments).
To study accounts payable, we recommend calculating and using the following indicators:
The amount of accounts payable balances;
Structure of accounts payable;
Accounts payable ratio;
Accounts payable to receivable ratio;
Overdue accounts payable ratio;
Amount of accounts payable. The data is taken from the “Balance Sheet”, accounts payable are shown in section 5 on page 1520. and “Appendices to the Balance Sheet and Profit and Loss Statement” from the fifth section Accounts Receivable and Payable, as well as subsections 5.3. Availability and movement of accounts payable and subsection 5.4. Overdue accounts payable. Based on the amount of accounts payable, their increase and decrease over a certain period is determined. It should be borne in mind that not every increase in them is a deterioration in financial condition. To do this, it is necessary to compare the growth rate of accounts payable with the growth rate of product sales and the growth rate of accounts receivable. If the growth rate of accounts payable is higher than the growth rate of product sales and receivables, this indicates a decrease in the efficiency of the enterprise and its insolvency.
Accounts payable structure, which is expressed as a percentage of each type in their total amount. Based on this indicator, the share of each type of accounts payable in their total amount is revealed, which depends on the settlement and payment discipline of the enterprise and the level of fulfillment of contractual obligations of each party. Particular attention should be paid to overdue accounts payable, the growth of which indicates a deterioration in the financial condition of the enterprise.
Accounts payable attraction ratio- characterizes the share of accounts payable in the total amount of economic assets; the higher this ratio, the greater the financial dependence of the enterprise, the more funds of other legal entities and individuals are involved in the enterprise’s turnover.
KRZ. - accounts payable;
K - the amount of economic assets (capital) of the enterprise.
The coefficient of involvement of accounts payable in the financing of working capital characterizes the share of accounts payable in working capital; the higher this ratio, the less working capital the enterprise has. If this ratio is greater than one, it means that part of the accounts payable is used to finance non-current assets, which is an unacceptable situation from the point of view of the solvency and financial stability of the enterprise.
Ob.S. - the amount of working capital.
Accounts payable to receivable ratio characterizes the share of accounts payable in accounts receivable and is determined by the formula:
KZ – accounts payable
DZ – accounts receivable
If this ratio is more than 1.0, this indicates an excess of accounts payable over accounts receivable, i.e. the funds raised in the total amount of economic assets exceed the funds held by other legal entities and individuals and, conversely, if this coefficient is less than 1.0, the funds transferred for use to other legal entities and individuals exceed the funds raised. It is desirable, in order to ensure the fulfillment of the contractual obligations of the enterprise and to optimize settlement and payment discipline, that the size of accounts receivable corresponds to the size of accounts payable in an equal amount.
Overdue accounts payable ratio- characterizes the share of overdue accounts payable in the total amount of accounts payable. An increase in this ratio indicates existing shortcomings in settlement and payment discipline, deterioration of the financial condition, settlement and payment discipline, and a decline in the liquidity and solvency of the enterprise.
KRZ – accounts payable
KRZpr - the amount of overdue accounts payable.
In the process of analysis, it is necessary to study the dynamics, composition, reasons and urgency of repayment of accounts payable, to determine whether it contains amounts for which the statute of limitations expires. If they exist, then it is necessary to urgently take measures to repay them. To analyze accounts payable, in addition to the balance sheet, materials from primary and analytical accounting, as well as “Appendices to the balance sheet and profit and loss statement” are used.
An employee involved in accounts payable management should focus on the oldest debts and pay more attention to large amounts of debt, and draw up a payment calendar.
It is also important to study the period for repayment of accounts payable:
Vkz – time of repayment of accounts payable
KZ – average balances of accounts payable
SКЗп – amount of repaid accounts payable
To characterize the quality of accounts payable, an indicator such as the share of bills of exchange in accounts payable is also determined. The share of accounts payable secured by issued bills of exchange in its total amount shows that part of the debt obligations, the untimely repayment of which will lead to protest of the bills, additional expenses and loss of business reputation.
These indicators are compared in dynamics with industry average data, standards, and the reasons for the increase in the length of the period for repaying accounts payable are studied (ineffective settlement system, financial difficulties of enterprises, long cycle of bank document flow, etc.).
To improve the financial condition of the enterprise, it is necessary to take measures to eliminate overdue accounts payable, as well as improve the settlement and payment discipline of the enterprise towards personnel, budget, suppliers, etc. enterprises. It is necessary to find out for each type of overdue accounts payable the reasons for their formation, the possibility of returning these funds, and develop specific recommendations for reducing them.
One of the important problems of attracting borrowed funds is their effective use. Borrowed capital should help increase the return on equity, increase profits and profitability of the use of capital in general.
One of the indicators used to assess the effectiveness of the use of borrowed capital is the financial leverage effect (FLE), which shows how much the return on equity increases by attracting borrowed funds into the turnover of the enterprise. It occurs when the return on total capital exceeds the weighted average cost of borrowed capital.
The effect of financial leverage can also be characterized as an increase in the return on equity capital due to the use of a loan, despite its fee.
Attracting borrowed capital will be effective when the growth rate of profits (income) of the enterprise will outpace the growth rate of the amount of assets, i.e. return on assets will increase.
The effect of financial leverage arises as a result of the excess of return on assets over the “price” of borrowed capital, i.e. average bank loan rate. In other words, the enterprise must provide such a return on assets so that there are enough funds to pay interest on the loan and income tax.
It should be borne in mind that the average calculated interest rate does not coincide with the interest rate taken from the loan agreement, since a loan at 10% per annum taken for 15 days, taking into account tax expenses, can cost the borrower 0.417% (10 x 15 : 360).
In the process of managing borrowed funds, financial managers should determine the required loan amount, the desired interest rate on it, and the impact of the loan on the level of return on equity.
The average estimated interest rate for using a loan (price of borrowed capital) is determined by the formula:
Rk – the amount of expenses for servicing borrowed capital (interest paid on the loan);
ZK – the amount of borrowed funds raised in the reporting period
Thus, the positive effect of financial leverage is formed when the return on assets exceeds the average calculated interest rate for the loan, i.e. R A > C ZK. In other words, in this case there will be an increase in the return on equity capital due to the use of credit.
A negative EFR value is obtained when the return on assets is lower than the average calculated interest rate for the loan, i.e. R A< Ц ЗК. В этом случае, отрицательная величина ЭФР приводит к снижению рентабельности собственного капитала, что делает не эффективным использование заемного капитала.
Thus, with a positive EGF value, an increase in the debt ratio will cause an even greater increase in the return on equity capital and the possibility of increasing the volume of activity of the enterprise. With a negative EFR value, an increase in the debt ratio will lead to an even greater drop in return on equity, a decrease in equity and, ultimately, can lead to bankruptcy.
The effect of financial leverage shows by what percentage the amount of equity capital increases (decreases) due to the attraction of borrowed funds into the turnover of the enterprise and is determined by the formula:
ZK – amount of borrowed capital;
Tax proofreader shows to what extent the EGF manifests itself in connection with different levels of taxation. It does not depend on the activities of the enterprise, since the profit tax rate is approved by law.
In the process of managing financial leverage, a differentiated tax adjuster can be used in the following cases:
If differentiated tax rates are established for various types of activity of the enterprise;
If the enterprise uses income tax benefits for certain types of activities;
If individual subsidiaries of the Enterprise operate in free economic zones (FEZ) of their country, where a preferential income tax regime applies, as well as in FEZ of foreign countries.
The second component of the effect is differential is a key factor forming a positive EGF. Condition: R A > Ts ZK
The higher the positive value of the differential, the more significant, other things being equal, will be the value of the EGF. Due to the high dynamics of this indicator, it requires constant monitoring in the process of managing financial leverage. The dynamism of the differential is determined by a number of factors:
a) during a period of deterioration in financial market conditions (a fall in the supply of loan capital), the cost of raising borrowed funds may increase sharply, exceeding the level of accounting profit generated by the assets of the enterprise;
b) a decrease in financial stability in the process of intensive attraction of borrowed capital leads to an increase in the risk of bankruptcy, which forces lenders to increase interest rates for loans, taking into account the inclusion of a premium for additional financial risk. As a result, the financial leverage differential can be reduced to zero or even a negative value. As a result, the return on equity will decrease, since part of the profit it generates will be used to service debt at high interest rates;
c) in addition, during a period of deterioration in the situation on the commodity market and a reduction in sales volume, the amount of accounting profit also falls. In such conditions, a negative differential value can be formed even with stable interest rates due to a decrease in the return on assets.
Thus, a negative differential leads to a decrease in return on equity, which makes the use of equity ineffective.
The third component of the EGF is debt-to-equity ratio characterizes the strength of the impact of financial leverage.
The debt ratio is a multiplier that changes the differential to a positive or negative value.
If the latter is positive, any increase in the debt ratio will cause an even greater increase in return on equity. If the differential is negative, an increase in the debt ratio will lead to an even greater drop in return on equity
So, with a stable differential, the debt ratio is the main factor influencing the return on equity, i.e. it generates financial risk. Similarly, with a constant debt ratio, a positive or negative differential generates both an increase in the amount and level of return on equity and the financial risk of its loss
This calculation method allows the company to determine the safe amount of borrowed funds, i.e., acceptable lending conditions. It is widely used in continental European countries (France, Germany, etc.).
To realize these favorable opportunities, it is necessary to establish the existence of a relationship and contradiction between the differential and the debt ratio. The fact is that with an increase in the volume of borrowed funds in the liabilities side of the balance sheet, the financial costs of servicing the debt increase, which in turn leads to a decrease in the positive value of the differential (with a constant return on equity).
From the above reasoning, the following conclusions can be drawn.
1. If new borrowing brings an enterprise an increase in the level of EGF, then it is beneficial for it. At the same time, it is necessary to monitor the state of the differential: with an increase in the debt ratio, the bank is forced to compensate for the increase in credit risk by increasing the “price” of borrowed funds.
2. The lender's risk is expressed by the value of the differential: the higher the differential, the lower the credit risk of the bank and vice versa.
A prudent financial director will not increase the debt ratio at any cost, but will adjust it based on the size of the differential. He is well aware that the future of the enterprise is based on its current financial position. Even if today the ratio between debt and equity is favorable for the enterprise, this does not reduce concerns about the forecast level of return on assets and the bank interest rate, and, consequently, the value of the differential.
Thus, an enterprise's debt to a bank is neither good nor bad, but it is its financial risk. By attracting borrowed funds, it can more successfully fulfill its objectives if it invests these funds in highly profitable assets or investment projects.
The key challenge for a financier is not to eliminate all risks, but to accept reasonable, pre-calculated risks within a positive differential. This rule is also important for the bank, since a borrower with a negative value causes distrust.
However, in practice, exceptions to this rule are possible. In certain periods of the life of an enterprise, it may be advisable to resort to active influence on financial leverage, and then weaken it. In other cases, it is advisable to observe moderation in attracting borrowed funds.
Many Western financiers believe that the “golden mean” is 30-50%, i.e. EFR should be equal to one third to half the level of return on assets. Then the EDF is able to compensate for tax payments and provide the desired return on its own funds.
It should be noted that the calculation of the EFR does not answer the question: what should be the marginal interest rate for a loan, above which it is unprofitable for an enterprise to enter into a loan agreement with a bank? Compliance with this rate in the loan agreement will allow the company to maintain the achieved level of return on equity.
KSP – marginal lending rate,%
US – discount rate of the Central Bank of the Russian Federation,%
PE – net profit in the billing period
PE 0 – net profit in conditions when the company did not use loans;
VB – balance sheet currency
ZK – borrowed capital
The average calculated interest rate for a loan is one of the main factors influencing the level of EFR. By concluding agreements with lenders with a high level of payment for a loan, the level of EFR is thereby reduced and vice versa. The management of the enterprise must strive to reduce interest rates for loans by selecting appropriate creditors and improving settlement and payment discipline at the enterprise, eliminating overdue accounts payable.
An increase in income tax rates leads to a decrease in the EFR indicator and, conversely, a decrease in income tax rates increases the effect of financial leverage. However, this factor does not depend on the management of the enterprise and it cannot influence the amount of tax imposed.
The amount of financial leverage (the ratio of debt to equity capital) depends on the amount of borrowed capital. The management of the enterprise must carefully study the feasibility of raising borrowed funds, the possibility of effective use and repayment within the terms established by the contract.
The EFR is also influenced by the inflation rate. In conditions of inflation, the return on equity increases, since the use of debt and its payment is made with already depreciated money, and the income and profit of the reporting year are formed taking into account inflation.
To calculate the EFR, taking into account inflation, Savitskaya G.V. recommends using the formula:
With NP - income tax rate (in coefficient);
R A – return on assets, %;
Ts ZK – price of borrowed capital (average calculated interest rate for a loan), %;
ZK – amount of borrowed capital;
SK – the amount of equity capital;
(1 - С np) – tax corrector;
(R A – Ts ZK) – differentiation of financial leverage.
Debt to equity ratio.
I – inflation rate (expressed as a coefficient)
When analyzing, it is necessary to determine the influence of the main factors on the deviation of the effect of financial leverage, for which it is possible to use the method of chain substitutions, since the original model is mixed.
To increase the effect of financial leverage, the management of the enterprise can further increase the leverage of financial leverage by attracting borrowed funds and using it effectively. Another factor in increasing EFR is increasing the profitability of using enterprise resources.
In international practice, EDF is also called “leverage”.
Leverage - from the English “leverade”, meaning a lever system, lever action, lifting force.
In economic theory, such concepts as “positive leverage”, “operational leverage”, “financial leverage”, etc. are used.
Positive leverage is when the income from raising additional borrowed funds exceeds the costs of them.
Operating leverage – characterizes the share of operating costs in the total costs of production.
There are three types of leverage: production, financial and production-financial.
Production leverage– the potential opportunity to influence gross income by changing the cost structure and output volume.
Financial leverage– the potential opportunity to influence the profit of the enterprise by changing the volume and structure of debt and equity capital.
Production and financial leverage– characterizes the relationship between three indicators: revenue, production and financial expenses and net profit.
The level of production leverage is determined by the formula:
Gross profit growth rate;
Growth rate of product sales in natural units.
The level of financial leverage is determined by the formula:
Net profit growth rate.
The level of production and financial leverage is determined by the formula:
K P-F.L. =K P.L. *K F.L.
When calculating various types of leverage, the dead center method is used. Using leverage calculation data, you can assess and predict the degree of production and financial investment risk.
Production risk is a risk caused by industry characteristics of production, i.e., the structure of assets in which the company decided to invest its capital; characterized by the variability of the “Profit from sales” indicator.
Financial risk is determined by the structure of capital sources.
If the share of fixed costs is large, then the enterprise has a high level of production leverage and high risk.
High financial risk is also associated with high financial leverage, due to the high share of borrowed capital, and therefore the amount of interest payable on it.
Financial stability reflects the financial condition of the organization, in which it is capable, through the rational management of material, labor and financial resources, of creating such an excess of income over expenses, in which a stable cash flow is achieved, allowing the enterprise to ensure its current and long-term solvency, as well as satisfy investment expectations owners.
The most important issue in financial stability analysis is assessment of the rationality of the ratio of equity and debt capital.
Financing a business using equity capital can be carried out, firstly, by reinvesting profits and, secondly, by increasing the capital of the enterprise (issuing new securities). Conditions limiting the use of these sources to finance the activities of the enterprise are the policy of distribution of net profit, which determines the volume of reinvestment, as well as the possibility of additional issue of shares.
Financing from borrowed sources requires compliance with a number of conditions that ensure a certain financial reliability of the enterprise. In particular, when deciding on the advisability of raising borrowed funds, it is necessary to assess the current structure of liabilities at the enterprise. A high share of debt in it may make it unreasonable (dangerous) to attract new borrowed funds, since the risk of insolvency in such conditions is excessively high.
By attracting borrowed funds, an enterprise receives a number of advantages, which, under certain circumstances, can turn out to be their downside and lead to a deterioration in the financial condition of the enterprise, bringing it closer to bankruptcy.
Financing assets from borrowed sources can be attractive insofar as the lender does not make direct claims regarding the future income of the enterprise. Regardless of the results, the creditor has the right to claim, as a rule, the agreed amount of principal and interest on it. For borrowed funds received in the form of trade credit from suppliers, the latter component can appear either explicitly or implicitly.
The presence of borrowed funds does not change the structure of equity capital from the point of view that debt obligations do not lead to “dilution” of the share of owners (unless there is a case of refinancing the debt and repaying it with shares of the enterprise).
In most cases, the amount of obligations and the timing of their repayment are known in advance (exceptions include, in particular, cases of guarantee obligations), which facilitates financial planning of cash flows.
At the same time, the presence of costs associated with fees for the use of borrowed funds is displacing enterprises. In other words, in order to achieve break-even operation, the company has to generate more sales. Thus, an enterprise with a large share of borrowed capital has little room for maneuver in the event of unforeseen circumstances, such as a drop in demand for products, a significant change in interest rates, rising costs, or seasonal fluctuations.
In conditions of an unstable financial situation, this can become one of the reasons for the loss of solvency: the enterprise is unable to provide a greater influx of funds necessary to cover increased expenses.
The presence of specific obligations may be accompanied by certain conditions that limit the freedom of the enterprise to dispose and manage assets. The most common example of such restrictive covenants are liens. A high proportion of existing debt may result in the lender refusing to provide a new loan.
All these points must be taken into account in the organization.
The main indicators characterizing the capital structure include the independence ratio, the financial stability ratio, the dependency ratio on long-term debt capital, the financing ratio and some others. The main purpose of these ratios is to characterize the level of financial risks of the enterprise.
Here are the formulas for calculating the listed coefficients:
Independence ratio = Own capital / Balance sheet currency * 100%
This ratio is important for both investors and creditors of the enterprise, since it characterizes the share of funds invested by the owners in the total value of the enterprise's property. It indicates how much an enterprise can reduce the valuation of its assets (reduce the value of assets) without harming the interests of creditors. Theoretically, it is believed that if this ratio is greater than or equal to 50%, then the risk of creditors is minimal: by selling half of the property formed from its own funds, the enterprise will be able to pay off its debt obligations. It should be emphasized that this provision cannot be used as a general rule. It needs to be clarified taking into account the specifics of the enterprise’s activities and, above all, its industry.
Financial stability ratio = (Equity + Long-term liabilities) / Balance sheet currency * 100%
The value of the coefficient shows the share of those sources of financing that the enterprise can use in its activities for a long time.
Long-term debt capital ratio = Long-term liabilities / (Equity + Long-term liabilities) * 100%
When analyzing long-term capital, it may be advisable to assess the extent to which long-term borrowed capital is used in its composition. For this purpose, the coefficient of dependence on long-term sources of financing is calculated. This ratio excludes current liabilities from consideration and focuses on stable sources of capital and their ratio. The main purpose of the indicator is to characterize the extent to which the enterprise depends on long-term loans and borrowings.
In some cases, this indicator can be calculated as an inverse value, i.e. as the ratio of debt and equity capital. The indicator calculated in this form is called coefficient.
Financing ratio = Equity / Debt * 100%
The ratio shows what part of the enterprise’s activities is financed from its own funds, and what part from borrowed funds. A situation in which the financing ratio is less than 1 (most of the enterprise’s property is formed from borrowed funds) may indicate the danger of insolvency and often makes it difficult to obtain a loan.
We should immediately caution against taking the recommended values for the considered indicators literally. In some cases, the share of equity capital in their total volume may be less than half, and, nevertheless, such enterprises will maintain fairly high financial stability. This primarily applies to enterprises whose activities are characterized by high asset turnover, stable demand for products sold, well-established supply and distribution channels, and low fixed costs (for example, trading and intermediary organizations).
For capital-intensive enterprises with a long period of turnover of funds, which have a significant share of assets for special purposes (for example, enterprises in the engineering complex), a share of borrowed funds of 40-50% can be dangerous for financial stability.
Ratios characterizing the capital structure are usually considered as characteristics of the enterprise's risk. The larger the proportion of debt, the higher the need for cash to service it. In the event of a possible deterioration in the financial situation, such an enterprise has a higher risk of insolvency.
Based on this, the given coefficients can be considered as tools for searching for “problem issues” in an enterprise. The lower the debt ratio, the less the need for in-depth analysis of capital structure risk. A high proportion of debt makes it necessary to necessarily consider the main issues related to the analysis: the structure of equity capital, the composition and structure of debt capital (taking into account the fact that balance sheet data may represent only a part of the enterprise’s liabilities); the ability of the enterprise to generate the cash necessary to cover existing obligations; profitability of activities and other factors significant for analysis.
When assessing the structure of sources of property of an enterprise, special attention should be paid to the method of their placement in the asset. This reveals the inextricable connection between the analysis of the passive and active parts of the balance.
Example 1. The balance sheet structure of enterprise A is characterized by the following data (%):
Enterprise A
An assessment of the structure of sources in our example, at first glance, indicates a fairly stable position of enterprise A: a larger volume of its activities (55%) is financed from its own capital, a smaller volume from borrowed capital (45%). However, the results of the analysis of the allocation of funds in the asset raise serious concerns regarding its financial stability. More than half (60%) of the property is characterized by a long period of use, and therefore a long payback period. The share of current assets accounts for only 40%. As we can see, for such an enterprise the amount of current liabilities exceeds the amount of current assets. This allows us to conclude that part of the long-term assets was formed at the expense of the organization’s short-term liabilities (and, therefore, we can expect that their maturity will occur earlier than these investments pay off). Thus, enterprise A has chosen a dangerous, although very common, method of investing funds, which may result in problems of loss of solvency.
So, the general rule for ensuring financial stability: long-term assets must be formed from long-term sources, own and borrowed. If an enterprise does not have borrowed funds raised on a long-term basis, fixed assets and other non-current assets must be formed from its own capital.
Example 2. Enterprise B has the following structure of economic assets and sources of their formation (%):
Enterprise B
| Assets | Share | Passive | Share |
| Non-current assets | 30 | Equity | 65 |
| Work in progress | 30 | Short-term liabilities | 35 |
| Deferred expenses | 5 | ||
| Finished products | 14 | ||
| Debtors | 20 | ||
| Cash | 1 | ||
| BALANCE | 100 | BALANCE | 100 |
As we can see, the liabilities of enterprise B are dominated by the share of equity capital. At the same time, the volume of borrowed funds raised on a short-term basis is 2 times less than the amount of current assets (35% and 70% (30 + 5 + 14 + 20 + 1) of the balance sheet currency, respectively). However, like enterprise A, more than 60% of assets are difficult to sell (provided that finished products in the warehouse can be fully sold if necessary, and all debtor buyers pay off their obligations). Consequently, with the current structure of placing funds in assets, even such a significant excess of equity capital over borrowed capital can be dangerous. Perhaps, in order to ensure the financial sustainability of such an enterprise, the share of borrowed funds needs to be reduced.
Thus, enterprises that have a significant volume of hard-to-sell assets in their current assets should have a large share of equity capital.
Another factor influencing the ratio of equity and borrowed funds is the cost structure of the enterprise. Enterprises in which the share of fixed costs in the total cost is significant should have a larger amount of equity capital.
When analyzing financial stability, it is necessary to take into account the speed of funds turnover. An enterprise with a higher turnover rate can have a larger share of borrowed sources in its total liabilities without threatening its own solvency and without increasing the risk for creditors (it is easier for an enterprise with a high capital turnover to ensure an influx of cash and, therefore, pay off its obligations). Therefore, such enterprises are more attractive to creditors and lenders.
In addition, the rationality of liability management and, consequently, financial stability is directly influenced by the ratio of the cost of raising borrowed funds (Cd) and the return on investment in the organization's assets (ROI). The relationship between the considered indicators from the perspective of their influence on return on equity is expressed in a well-known ratio used to determine the influence:
ROE = ROI + D/E (ROI - Cd)
where ROE is return on equity; E - equity capital, D - debt capital, ROI - return on investment, Cd - cost of attracting debt capital.
The meaning of this ratio is, in particular, that while the profitability of investments in an enterprise is higher than the price of borrowed funds, the return on equity will grow the faster, the higher the ratio of borrowed and equity funds. However, as the share of borrowed funds increases, the profit remaining at the disposal of the enterprise begins to decline (an increasing part of the profit is directed to paying interest). As a result, the return on investment falls, becoming less than the cost of borrowing. This in turn leads to a drop in return on equity.
Thus, by managing the ratio of equity and debt capital, a company can influence the most important financial ratio - return on equity.
Options for relating assets and liabilities
Option #1
The presented scheme of the ratio of assets and liabilities allows us to talk about a safe ratio of equity and borrowed capital. Two main conditions are met: equity capital exceeds non-current assets; current assets are higher than current liabilities.
Option 2
The presented scheme of the ratio of assets and liabilities, despite the relatively low share of equity capital, also does not cause concern, since the share of long-term assets of this organization is not high and equity capital fully covers their value.
Option #3
The asset-liability ratio also demonstrates the excess of long-term sources over long-term assets.
Option No. 4
At first glance, this version of the balance sheet structure indicates insufficient equity capital. At the same time, the presence of long-term liabilities allows long-term assets to be fully formed from long-term sources of funds.
Option #5
This structural option may raise serious concerns about the financial stability of the organization. Indeed, it can be seen that the organization in question does not have enough long-term sources for the formation of non-current assets. As a result, it is forced to use short-term borrowed funds to form long-term assets. Thus, it can be seen that short-term liabilities have become the main source of formation of both current assets and, partly, non-current assets, which is associated with increased financial risks of the activities of such an organization.
At the same time, it should be emphasized that final conclusions regarding the rationality of the structure of liabilities of the analyzed organization can be made on the basis of a comprehensive analysis of factors that take into account industry specifics, the rate of turnover of funds, profitability and a number of others.
