Suppose you wish to operate a lemonade stand. To keep things simple, we won’t be factoring in any taxation.
We begin by investing $100 of our own money as Equity into the business to be able to buy the assets you need, like the stand, equipment, and inventory (got to have lemons) you need to produce the lemonade.
After selling lemonade for a time, you manage to make a profit (net income) of $10.
In business terms, your Return on Equity (RoE = Profit / Equity) is 10%.
Because you managed to get a good return, you want to grow the business. In this example, it means launching another lemonade stand with another $100 investment.
At this point you have two options:
- You can wait until you have generated enough cash from the first stand to finance the second stand with your own money. This is known as “bootstrapping”.
- Obtain a loan from a bank for $100. This means you will take on debt.
You decide to go with the loan option because you see the opportunity to grow and you don’t want to wait.
The bank wants to make money as well, so they will charge you interest for the money they will give you. In this example, we’ll say they are charging you 4%.
You will incur an interest expense of $4 for the second lemonade stand.
The operating profit of the second stand is also $10. When we deduct the $4 interest expense you make a net income of $6.
Together with the first stand, you now have a net income of $16.
The equity which was your own money that you put into the business remains $100. This means that your Return on Equity (RoE) is 16%.
Working with other people’s money improved your RoE.
Because business is great and you want to grow further, you again go to the bank to get another loan of $100 at 4% interest.
The third stand makes the same profit as the first two stands; a profit of $10 minus $4 for interest gives you a net income of $6.
When combined with the other two stands you have a net income of $22 on your $100 equity. The RoE is now 22%.
By taking advantage of the leverage effect, you managed to more than double your RoE.