What is Leverage effect of debt?

Leverage is the financial instrument in the form of debt , which companies use to increase their profitability.

Confused?

You might be thinking how taking debt can potentially increase the company's profits?

Let us take a simple example.

Let us assume a company which manufactures cars.

Company needs 100 Cr Rs. as an investment for its factory, land, machines etc.

Profitability of a company depends on its investments.

Company sells its products and makes a profit of 10% i.e. 10 Cr Rs.

Now the company takes loan of another 100 Cr. Rs. at interest rate of 7 %.

Now company has total investment of 200 Cr. Rs on which it makes a profit of 20 Cr. Rs.

Company pays bank  107Cr Rs. i.e. 100 Cr. principal and 7Cr interest.

Thus Company's profit on investment is 13 Cr. Rs on 100 Cr.Rs

Hence company made profit on investment of 13% instead of 10 % earlier.


What are the obstacles then?

1. If the economy is going through deflation then debt can really create a big problem. This was discussed in my earlier blog post
http://isheconomist.blogspot.in/2015/11/is-deflation-good-or-bad.html

2. If the REPO-RATE is high then company has to take loan at higher interest rate and hence  can create problem for a company. This was discussed in my earlier blog post
http://isheconomist.blogspot.in/2015/11/what-is-repo-rate-how-does-it-affect-me.html


How can I use Leverage Information?

If you want to buy shares of certain company then go to its balance sheet and check the amount of debt that the company has on its books.

Check what is the current REPO-RATE on RBI's website.

See the growth rate of the economy and growth rate of the industry in which company operates.

Using this information you can approximately predict the company's performance in coming years.

Then you can decide whether to buy the shares or not.



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