Leverage: The other side of debt

When I think of Filipino small and medium business 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 business with debt, which he refused. “Never spend money that you don’t have or that doesn’t belong to you,” he told me. I was surprised to learn that in his many years of running his businesses, he never used debt to finance them. That night we had a long discussion about leverage, a term he hadn’t heard of until then.

Leverage is a measure of the use of fixed costs versus variable costs, so financial leverage answers the question, “How much of your business is financed by debt (your fixed costs? ) in relation 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 return in this case, we are talking about our return on equity or ROE. It’s a financial ratio calculated by dividing your period’s net income by the average equity for the same period, and what it basically tells us is that out of your own invested capital, how much have you been able to profit from it? Take for example a company that needs a million pesos of capital with a profit before tax (EBT) of 150,000 P. With a stock investment of 1 million pesos, you get a net income (ignoring the calculations tax) of 150,000 pesos and an ROE of 15%. Now introduce debt financing at an interest rate of 6% (keeping the net income calculations in the background): with a debt-to-capital ratio of 20% (P200,000 of principal from debt and 800 P,000 from equity), your net income goes down to P138,000, but your ROE goes up to 17%. With a debt to capital ratio of 50%, the net income is 120,000 pesos and the ROE is 24%. And with a debt-to-equity ratio of 80%, net income is P 102,000, while ROE is 51%. The bottom line is this: Your nominal earnings in the form of net income decrease due to additional interest charges, but your ROE increases because you use less of your own money to make those profits.

However, most people can say that they would rather have a higher net income than a higher ROE. After all, how does a percentage increase in a financial ratio compare to higher actual cash profits? Additionally, some may think that the benefits of leverage only apply to businesses, as it is relatively easier and faster for them to get into debt than it is to have additional equity. In contrast, for a sole proprietorship, or partnership, issuing additional equity would be much easier, since the owners have the additional money to pay. This explains my father’s and those of similar small business owners’ reservations about debt. So why go into debt? The answer: opportunity cost and diversification.

Let’s go back to our previous example: the difference between using a 100% equity financing and a 50-50 split was P30,000.00 in net income for an additional investment of P500,000.00. -you could earn with those 500,000 P if you had invested them instead, for example, in the Philippine Stock Exchange by buying the shares of Jollibee, which has appreciated by more than 120% since mid-March of this year ? The answer: around 600,000 P. After deducting the interest you paid on the debt you issued, you would still have earned 570,000 P. It is important to remember that as an entrepreneur, your business, in which you spend money to generate profit, is an investment and all of your money constitutes a wallet. Diversification, given the less than perfect correlation between the returns of different investments, always reduces the total risk of a portfolio. When you use leverage on your investments, you are able to spread your limited equity among different assets, while still being able to fund and scale each one. A good exercise is to ask yourself, “What else can I do with my own money besides putting it into my current business?” For each additional peso I put into my business, how much more can I earn? What will my returns be on other investments, should I invest my money in public stocks, debt securities, property and / or a new business instead? »Identify marginal returns per additional peso of capital invested in your business, compare them with returns from other investments, factor in interest rates on debt and decide: Should I take advantage of my position?

A graduate of Ateneo de Manila University with a BA in AB Management Economics, Dylan works as a financial analyst at First Circle. He prepares financial and operational reports both for the management of the company and for external investors.

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