Leverage involves using borrowed funds to finance the acquisition of assets, with the expectation that the income generated or the capital gain will exceed the cost of borrowing. In financial terms, this is referred to as financial leverage.
In typical scenarios, the entity providing the financing sets limits on the risk it is willing to take and the extent of leverage it will accept. Asset-backed lending involves using the borrower's assets as collateral until the loan is repaid. In the case of working capital loans, the overall creditworthiness of the company is leveraged to secure the loan.
Functioning of Financial Leverage:
When a corporation seeks to acquire assets, it has three main financing options: debt, equity, and leases. Except for equity, the other options involve fixed expenses that are lower than the actual capital obtained from the assets.
In the example below, let's consider a scenario where the company opts to borrow money to acquire assets.
Example of Leverage:
Suppose Company Z aims to purchase a $100,000 asset. The company can choose between equity or debt financing. Opting for equity means outright ownership of the asset without incurring interest payments. If the asset appreciates by 40%, reaching a value of $140,000, the company gains a profit of $40,000. Conversely, if the asset depreciates by 40%, with a value of $60,000, the company incurs a loss of $40,000.
Alternatively, the company may choose to fund the asset using a 50/50 mix of common stock and debt. In this case, if the asset appreciates by 40%, its value will be $140,000.
Ways to calculate financial leverage
The Debt-to-Equity Ratio is a crucial financial metric that indicates the proportion of a company's debt to its equity, providing insight into the level of financial leverage. This ratio is instrumental for management, lenders, owners, and stakeholders in assessing the risk associated with the company's capital structure. It helps in gauging whether the borrowing entity may face challenges in meeting debt obligations or if its leverage is at a healthy level. The formula for calculating the Debt-to-Equity Ratio is:
In this context, "total debt" encompasses the company's current obligations, including debts due within the next year, while "protracted liabilities" refer to loans with a maturity exceeding one year.
The term "equity" encompasses shareholder equity, representing the amount invested by shareholders, along with reserves and surplus, which denotes the portion of profits retained by the company.
It's notable that manufacturing firms often exhibit a higher debt-to-equity ratio compared to service firms, reflecting their increased investment in equipment and assets.
In addition to the Debt-to-Equity Ratio, there are other significant leverage ratios commonly employed in corporate finance to evaluate financial risk:
Debt-to-Capital Ratio
Debt-to-EBITDA Ratio
Interest Coverage Ratio
While financial leverage can enhance a company's profitability, it also poses risks, particularly in the form of higher losses. These losses may occur when the interest obligations on assets surpass the returns generated by the assets, potentially due to a decline in asset value or when interest rates reach unsustainable levels.
Irregular Stock Price
Heightened financial debt can lead to significant fluctuations in a company's earnings, causing the stock price to become more erratic. This volatility poses challenges in accurately accounting for share options held by corporate employees. Additionally, as stock prices rise, the company may need to distribute more substantial shares to its shareholders.
Bankruptcy
Firms with low entry barriers are more susceptible to fluctuations in earnings and revenues compared to those with high fixed costs. Accumulating unsatisfactory debt commitments and struggling to meet operational expenditures during income changes can swiftly push a company into debt and potential liquidation. In such scenarios, looming unpaid bills may prompt creditors to initiate bankruptcy proceedings, aiming to sell the firm's assets to recover their obligations.
Reduced Risk of Future Debts
Lenders assess a company's financial leverage when extending loans. Companies with a significant debt ratio may face reluctance from lenders to provide additional funds due to the elevated risk of non-payment. If lenders decide to grant loans to a highly leveraged company, they typically expect higher interest rates to compensate for the increased risk of default.
Operating Leverage Explanation:
Operating leverage is the ratio of fixed expenses to variable costs within a specified timeframe for a company. When a company's fixed costs exceed its variable costs, it is considered to have significant operating leverage. Such companies face challenges with fluctuations in sales volume, and this instability can impact metrics like EBIT (Earnings Before Interest and Taxes) and return on invested capital.
For instance, manufacturing companies, which often require machinery for production, commonly experience high operational leverage. Regardless of sales variations, these companies must cover fixed expenses such as equipment depreciation, facility overhead, and maintenance costs.
Definition of Leverage:
Leverage refers to the utilization of borrowed capital or funds to amplify returns from a project or investment.
Significance of Leverage:
Leverage provides investors with the opportunity to enhance their market position by using borrowed funds. Instead of issuing shares for capital, companies may opt for debt to invest in specific initiatives, aiming to improve overall shareholder value.
Disclaimer
Derivative investments involve significant risks that may result in the loss of your invested capital. You are advised to carefully read and study the legality of the company, products, and trading rules before deciding to invest your money. Be responsible and accountable in your trading.
RISK WARNING IN TRADING
Transactions via margin involve leverage mechanisms, have high risks, and may not be suitable for all investors. THERE IS NO GUARANTEE OF PROFIT on your investment, so be cautious of those who promise profits in trading. It's recommended not to use funds if you're not ready to incur losses. Before deciding to trade, make sure you understand the risks involved and also consider your experience.
