Leverage Effect – Fine Line Between Opportunity and Risk

Borrowing debt to improve equity return is an opportunity for businesses. Since not all funds need to be raised on their own, resources can be used efficiently and good results can be presented to investors. However, there are also risks of loss.

The effect of borrowing debt on the return on equity is called the leverage effect or gearing effect. The return on equity shows the net profit achieved in relation to the equity employed. If the company's activities are partly financed by debt, a proportionally higher profit accrues to each unit of equity used. A desired (positive) leverage effect occurs when the costs for borrowing the debt are significantly lower than the company profit achieved.

Positive leverage effect as an opportunity

Suppose an entrepreneur has 100 CHF in equity, which he can use profitably. If he invests the entire 100 CHF in a project with a return of 10 percent, the entrepreneur generates 110 CHF. In this case, the equity return corresponds to the project's return. By taking on debt, this value can be improved or worsened.

If the entrepreneur can borrow another 100 CHF from a bank, he has 200 CHF at his disposal. Interest of 5 percent must be paid on the borrowed money. The expected return of the project amounts to 220 CHF. From this money, the entrepreneur has to pay back 105 CHF to the bank. He retains 115 CHF and an equity return of 15 percent.

Negative leverage effect as a risk

However, playing with leverage can also backfire. If the expected return drops to 5 percent, the project only yields 210 CHF. The entrepreneur still has to pay 105 CHF to the bank. The entrepreneur's equity return now amounts to 5 percent and is thus less than without borrowing funds. If the costs for borrowing the funds increase or the return on the project further decreases, the entrepreneur even incurs a loss.

Leverage effect in startups

For startups, using the leverage effect can be an opportunity. Particularly in the beginning, it is important to use resources as effectively as possible and to present good financial metrics to investors. The pros and cons of borrowing debt must be weighed against each other to find the right capital structure.

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