What does leverage mean in finance?
Generally, the word leverage refers to an investment strategy of specifically borrowed money for various financial instruments such as lending to increase the potential return of an investment by a shareholder. In other cases, the term leverage can also be used to define the amount of debt used by a firm to finance the purchase of various assets.
This concept of leverage has used both companies and investors to significantly increase investment returns while reducing the downside risks in case of a loss, thus ensuring that the business does not pan out. The investors lever their investments by using several instruments such as margin accounts, options, and futures.
How financial leverage works
When financing the purchase of assets, a company has three available options: using debt, equity, and leases. Typically it’s critical to note that those companies are supposed to issue stock to raise capital. Still, in this case, they give debt financing to invest in their business operations, thus increasing their shareholders’ values. In some other cases, some investors are not comfortable with the risks of directly using leverage; hence, such investors can also opt for indirect ways of accessing those leverage. For example, by using the balance sheet analysis, those investors can decide to invest in companies that use leverage in the usual courses of their business to finance or expand their businesses without necessarily increasing their outlay.
Why companies Leverage Finances
Leverage is simply a tactic geared towards multiplying and losses. The leveraging of assets by any companies to get exponentially more return can be an extensive risk process; thus, this represents a significant aspect of financial strategies and capital structures. Despite the risks associated with financial leverages, this process’s complete achievement provides the company with a competitive advantage since it accelerates the exponential speed of revenue acquisition.
The standard way of accomplishing financial leverage is through borrowing via equity and debts, which is invested at a larger scale than the shareholders’ current assets can allow. Therefore to borrow a substantial amount of capital, firms pursue various financial sourcing while simultaneously returning their debts with valuable support. Companies use interest rates in the calculation to ensure they balance their obligations with their assets and reduce the risks that come with leverage financing, taking into account the return trade-offs and risks. But it’s critical to note that even with the above strategies, when a company decides to venture into leverage financing, it will face a significant bankruptcy risk if it fails.
The method of measuring financial leverage
To measure the amount of financial leverage of an entity, debt –to- equity ratio is used. This method shows the companies’ equity to the proposition of debt, thus helping the company’s management understand the level of risk involved in the company’s capital structure. They can understand the likelihood of facing difficulties in meeting the obligations of their debts or, on the other hand, determine if the levels of their leverages are at a healthy level.
Other methods of measuring financial leverage include:
• Interest Coverage Ratio.
• Debt to EBITDA Ratio.
• Debt to Capital Ratio.
The advantages of financial leverage.
• It’s one of the solid ways of accessing capital.
Whenever financial leverage is correctly deployed, turbo boosts the amount of financial capital accompany deploys. It is based on the fact that economic power enables the companies to produce a higher investment return rate than it would have created without using the leverage.
• Financial leverage is good for business expansion ventures
Suppose a company requires to address a given short term business objective such as the buyout of another company, engaging in an acquisition, or buying out a shareholder’s dividends. In that case, financial leverage is one of the most effective, reliable ways.
The risks associated with financial leverage.
• Insufficient returns from the asset
In most cases, financial leverage results in enhanced earning to the company involved but in other cases, when the interest expense payment of the assets overwhelm the borrower ( based on the fact that the returns from the investments are insufficient), it may also result into a significant loss for the company. Hence, for this reason, first-time investors are advised to avoid leverage until they acquire more operation experience. It’s critical to note that for companies that high right, liberal use of leverage in their terms freely uses leverage to generate their shareholder’s wealth. This process’s failure places the shareholders’ investment at a great interest expense and credit risk of default, thus destroying their shares’ value.
A business with low barriers to entry may face fluctuations in the amounts of revenues and profits. Those fluctuations, especially in revenues, will force the company into bankrupts since it will not meet its rising debts obligations and payment of operating expenses. In such cases, creditors are forced to file a lawsuit in a bankruptcy court to have the business’s assets auctioned to retrieve their owned debts.
• Volatility in the prices of stocks.
An increased amount of financial leverages usually result in large swings of the company’s profits. Those large swings in yields lead to a frequent rise and fall in the company’s stock price. This case scenarios usually hinder the proper accounting of the company’s assets; hence increased stock prices will lead to the company paying higher interest rates to their shareholders without considering the in-between losses caused by the fall in those stocks.
• The costs of operating leverage.
Operating leverage refers to the ratio of fixed costs to a company’s variable values in a specific period. If a company’s fixed costs exceed the number of varying prices, it is considered high operating leverage. For such companies, changes in volumes of sales and volatility significantly affect its EBIT and returns on invested capital. This case scenario is mostly experienced by capital intensive firms such as manufacturing firms since they require numerous machines in the manufacture of their products. Those companies are forced to pay fixed costs for depreciation in equipment, maintenance costs, and overhead on manufacturing plants regardless of whether they make profits or not.
• The reduction of accessibility to more debts.
To rent money to companies, financial providers first critically access the company’s level of financial leverage. For those companies with a high debt-to-equity ratio, lenders may deny investing more funds since this kind of firm has an increased risk of default. Therefore if a render agrees to advance funds to this kind of company (with high default), they charge high-interest rates that may be impossible to compensate based on the increased risks of default.