Financial leverage is the use of borrowed funds to finance the purchase of assets with the expectation that income or capital gains from new assets will exceed the cost of borrowing.
In most cases, the loan provider will impose a limit on how much risk it is willing to take and a limit on the extent to which it can be availed. In the case of asset-backed lending, the financial provider uses the assets as collateral until the borrower repays the loan. In the case of a cash flow loan, the company’s general credit is used to pay back the loan.
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How financial leverage works
When purchasing a property, the company has three options available to obtain financing: using equity, debt, and leases. In addition to property, the rest of the benefits have fixed costs that are lower than what the company expects to earn from the asset. In this case, we believe that the company uses debt to finance asset acquisition.
Suppose Company X wants to acquire a property that costs $ 100,000. The company can use either equity or debt financing. If the company opposes the first option, it will have 100% of the assets, and no interest payments. If the asset appreciates at 30% of its value, the asset’s value will increase to $ 130,000 and the company will make a profit of $ 30,000. Similarly, if the asset falls below 30%, the asset will be valued at $ 70,000 and the company will incur a $ 30,000 loss.
Alternatively, the company can go with the second option and finance the asset using 50% common stock and 50% debt. If the asset appreciated by 30%, the asset would be valued at $ 130,000. This means that if the company refunds the $ 50,000 debt, it will remain at $ 80,000, which turns into a profit of $ 30,000. Similarly, if the asset falls below 30%, the asset will be valued at $ 70,000. This means that after repaying the $ 50,000 loan, the company will remain with $ 20,000 which turns into a loss of $ 30,000 ($ 50,000 – $ 20,000).
How financial leverage is the measured
Debt to Equity Ratio
The debt-to-equity ratio is used to determine the amount of financial leverage of an entity and refers to the ratio of debt to equity of the company. It helps the company’s management, lenders, shareholders, and other stakeholders understand the level of risk in the company’s capital structure. It is likely that the borrower unit is facing difficulties in meeting its debt obligations or if the leverage level is at a healthy level.
Total debt, in this case, refers to the company’s current liabilities (debt that the company intends to pay within a year or less) and long-term liabilities
Equity refers to the shareholder’s equity (the amount invested in the company) as well as the amount of income held on it (the amount the company has derived from its profit).
Companies in the manufacturing sector typically report a higher debt to equity ratio than companies in the service industry, reflecting a higher amount of prior investment in machinery and other assets. Typically, the ratio is higher than the US average debt to equity ratio of 54.62%.
Other leverage ratios
Other common leverage ratios used to measure financial leverage include:
- Debt to capital ratio
- Ratio to Debt EBITDA
- Interest radio
While the debt to equity ratio is the most commonly used leverage ratio, the above three ratios are also often used in corporate finance to measure a company’s leverage.
Risks of financial leverage
Although financial leverage can increase earnings for a company, it can also result in disproportionate losses. Losses can occur when the borrower incurs payment of interest expense for the asset because the return from the asset is not sufficient. This can happen when property values or interest rates fall, rising to unbearable levels.
Stock price volatility
Increased amounts of financial leverage can result in a large decline in company profits. As a result, the company’s stock price will rise and fall more frequently, and it will hinder proper accounting of stock options owned by the company’s employees. An increase in stock prices would mean that the company would pay higher interest to shareholders.
In a business where there are fewer barriers to entry, revenue and profits are more likely to fluctuate than a business with higher barriers to entry. Revenue fluctuations can easily push a company into bankruptcy because it will be unable to meet its growing debt obligations and pay its operating expenses. Along with reducing unpaid debts, creditors may have filed a case in bankruptcy court to auction the business’s assets.
Decreased access to more loans
When lending money to companies, financial providers assess the firm’s financial level. For companies with high debt-equity ratios, lenders are less likely to advance additional funds because of greater risk of default. However, if lenders agree to give the upfront funds to a highly-leveraged firm, it will lend at a higher interest rate that is sufficient to compensate for the higher risk of default.
Operating leverage is defined as the ratio of fixed costs to variable costs incurred by a company over a specific period of time. If the fixed cost exceeds the variable cost, the company is considered to have high operating leverage. Such a firm is sensitive to changes in sales volume and volatility can affect the firm’s EBIT and return on invested capital.
High operating leverage is common in manufacturing firms such as capital-intensive firms because they require a large number of machines to manufacture their products. Regardless of whether the company makes a sale or not, the company is required to pay fixed costs such as depreciation on equipment, overhead on manufacturing plants, and maintenance costs.
The CFI Financial Modeling and Valuation Analyst (FMVA) ™ designation is the official global provider of a major financial analyst certification program. In order to learn and advance your career, these additional resources will be helpful:
- leverage ratio
- Analysis of financial statements
- Evaluation multiplier