Financial analysis : Question 6
I'd like to know how the leverage effect can be used in a mass market retail company.
The leverage effect comes into play regardless of the sector. Taking out a loan at 3% after tax, the sort of rate available on the market at the moment, and putting the money into capital employed at a rate of say 10%, will increase the return on equity to more than 10%. On the other hand, taking out a loan at 3% and getting 0% on the funds will reduce return on equity to below 10%. For more information, see chapter 13 of the Vernimmen.
Because of the way the mass market retail segment works, with negative working capital, which is a source of cash, companies operating on this segment do not, in theory, need to take out banking loans, which means that the leverage effect does not come into play. This is only the theory however, as a mass market retail company could well decide to borrow to finance a major acquisition, for example, which exceeded its cash provided by its negative working capital. This brings us back to the general situation described in the first part of the answer.
Because of the way the mass market retail segment works, with negative working capital, which is a source of cash, companies operating on this segment do not, in theory, need to take out banking loans, which means that the leverage effect does not come into play. This is only the theory however, as a mass market retail company could well decide to borrow to finance a major acquisition, for example, which exceeded its cash provided by its negative working capital. This brings us back to the general situation described in the first part of the answer.