The Leverage Effect.

Geordon Saraveloz June 3, 2021 0 Comments

Opportunity explained: The Leverage Effect.

In business, credit enhancement is usually applied to make a company more creditworthy to reduce the cost of borrowing or to access fund in the first place. Credit Enhancement can place any company in a better credit position to qualify for loans, to start or build projects or trade products and commodities.

Cash rich and well established large corporations get this service through their banking relations at lowest rates and with this have leverage on available capital.

Smaller enterprises will have to pay heavy fees to qualify for any credit enhancement service in the first place. However, revenues that can be generated by applying credit enhancement to achieve financial leverage usually outweigh the costs of financing significantly.

A basics understanding of the Leverage Effect

Imagine an entrepreneur has 100,000 in equity capital at his disposal. He wants to invest the money with the highest possible return. He is offered a project that generates a 10% return. He could therefore invest all his money and have 110,000 at the end of the project. In this case, he does not use the leverage effect, but simply invests his own money.

If we now assume that this is not enough for the entrepreneur, then he has to think about something to earn more than 10% interest on his 100,000. His plan: He takes out a loan and puts the additional money into the (10% return) project. He finds a bank that lends him another 100,000 and charges him 5% interest. This allows him to invest a total of 200,000 in the project.

What does he get out of it? If the project runs exactly as he imagined, he will end up with a total of 220,000, namely 200,000 in start-up capital plus a 10% return on investment. However, the entrepreneur is not allowed to keep all the money for himself. Firstly, he has to pay the 100,000 back to the bank and secondly, there are interest costs of 5% or 5000. Of the 220,000, 105,000 go back to the bank. The entrepreneur keeps the remaining 115,000 for himself. He thus increases his equity by 15,000. In other words, he achieves a return on equity of 15%.

The entrepreneur was able to increase his return on equity from 10% to 15% by taking out a short-term loan. In other words, he has used the leverage effect.

How can this be? Let’s look at leverage again. The entrepreneur borrowed 100,000 and was able to increase the assets by 10% to 110,000. However, he only had to pay interest of 5% or 5000. He can keep the difference for himself. This means that his own capital of 100,000 not only increases by 10,000 due to his own investments, but also by the 5,000 he made with the profit from the borrowed capital.

More profit with the same equity capital results in a higher return on equity. This is exactly the leverage effect. You increase your own return by increasing your debt. The entrepreneur could even increase this effect at a grater extend, if he had borrowed another 100,000 and thus invested 300,000.00 in the project. In that case he would have even ended up with a 20% return on equity.

Unfortunately, the leverage effect can also turn negative. Then the debt no longer leads to a particularly high return on equity, but to a particularly low one.

Let’s take another look at the project. The entrepreneur has again taken out a loan of 100,000 at 5% interest and invests a total of 200,000. Unfortunately, the project is running quite badly and only generates a 2% return. The target of 10% is therefore missed by a considerable margin. In this case, the entrepreneur has a problem. After the project, he has a total of 204,000, i.e. 200,000 + 2% return. But first he has to pay off his debts and, as before, repay 105,000 to the bank. He only has 99,000 left for himself. Compared to the beginning, he has lost 1000. This means a return of -1%. His return on equity is therefore negative, although the project as a whole has achieved a positive return of 2%. This is not enough to cover the costs of his loan.

The result: the entire project is positive. The bank makes a profit. Only the entrepreneur makes a loss. In this case, one speaks of leverage risk. The debt has significantly reduced the return on equity.

When does the leverage effect work positively and when negatively?

The decisive criterion is the following: If the total return is higher than the return on debt, i.e. the interest costs, then the leverage effect works positively. With the additional profits, not only can the interest be paid, but there is also something left over for the entrepreneur himself.

However, if the total return on the investment is less than the return on debt, i.e. less than the interest costs, then things no longer look so good. Then the profits are no longer sufficient to cover all the interest costs and the investor has to contribute something from his own capital.

But how is the Leverage Effect connected to Credit Enhancement? Through the loan an entrepreneur will have to get access to actually leverage his capital. And this again is related to the entrepreneur’s credibility. And this again, can be achieved through Credit Enhancement. We have the knowhow and the tools that can increase the total return on your investment, or enable that you can start a project in the first place.

If you want to have Leverage on your own capital, or start a project using Credit Enhancement, get in touch! Call Morris on +353.86.0325153. This phone number also works on Whatsapp, Signal, Telegram and WeChat.