Using debts as the fund for company could be used to raise the company performance. It is called the financial leverage. What does it mean? And what is the risk?

The company formed with the stock capital from the owner. The return rate for the investor for the investment in the company could be calculated with the Return on Equity ratio with the formula:

ROE= Net Profit/ Equity

Shoud the company use the debts as the fund, the shareholder will get benefit upon the return rating. How is it?

To make it more simple, we take example, two companies ABC and XYZ with the same assets and net profit each Rp 100M and Rp 20M. The difference is that ABC only used the investor's capital Rp 75M, while XYZ uses the investor's capital Rp 40M and the loan fund Rp 35M.

To make this example close to the real practice, we need to lower XYZ net profit with the interest expense appears upon the debts used. For instance, the interest rate is 20%, XYZ would have the interest expense Rp 7M. Therefore, XYZ should make net profit Rp 13M.

So, then we find that XYZ has ROE 32.5% (Rp 13M divided into Rp 40M), which is bigger than ABC ROE which only 27% (Rp 20M divided into Rp 75M).

It can be seen that XYZ uses the loan fund to make profit for XYZ investors. Notes that besides to increase the return for investors, the financial leverage also to increase the financial risk of the company. It because the company would be burdened by the loan interest that finally can burden the net profit and company cash flow. And should the debt gets bigger; the creditors would implement the higher interest rate to compensate the rise of the financial risk.

To be informed about how big the company gets the financial risk, we could use the Debt to Equity Ratio measure that divides the debts into the equity. There is no certain limit how much is the save D/E, but for the conservative, usually the more than 66% (or 2/3) D/E is considered risky.

The other measure that can be used is the Interest Coverage that counts how many times the operating profit fro the interest expense. The 3x interest rate means the operating profit is three times as much as the interest expense.

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