Financial leverage is the utilisation of borrowed funds (debt) rather than equity in the purchase of an asset. The usage of financial leverage comes with the assumption that after-tax income and capital gain generated from the asset to equity holders exceed the borrowing cost of debt. Financial leverage is also referred to as leverage or trading on equity.
Financial leverage enables returns on investment to be amplified, often in multiples of the borrowing cost. Correspondingly, it comes with the associated risk of increased losses, in the event the asset value decreases or financing costs exceed the profit generated from the asset.
Hence, in most scenarios, the lender imposes a limit on the degree of leverage permitted and may require the asset to be lodged as collateral to secure the loan until the borrower repays it in full.
Read also: What is Loan-to-Value (LTV) Ratio?
What are financial leverage ratios?
Financial leverage ratios measure the amount of capital that is in the form of debt. They also assess the ability of a company to meet its financial obligations. As most companies depend on a mix of debt and equity to finance their businesses, having a knowledge of the amount and proportion of debt held is useful to determine if the level of debt is suitable and whether the company can repay its debts. An uncontrolled, steep debt level is a warning sign for investors. On the other hand, debts, which are too low, may signal tight operating margins or inability to take advantage of tax deductions arising from interest cost of debt.
Read also: Knowing your capital stack
There are several financial leverage ratios that measure the performance of the company, as described below:
The most common ratio used is the debt-to-equity ratio or D/E ratio. D/E ratio reflects the proportion of borrowed funds (debt) to funds raised from shareholders (equity) of a company. It allows management, lenders, shareholders and other stakeholders to understand the risk level of the company’s capital structure by examining the ratio of borrowings to the owners’ fund.
Typically, the higher the D/E ratio, the more aggressive a company has been pursuing growth with debt. This results in higher volatility of earnings and interest expense, with an increased likelihood of the company failing to meet its debt obligations and a higher risk of bankruptcy and insolvency, thereby exposing a weak financial position of the company. This particularly induces greater risk exposure in a higher interest rate regime.
The formula for calculating D/E ratio is as follows:
Total debt refers to both the current and non-current liabilities incurred by the company: debts which the company intends to pay within a year and debts with more than one year of maturity.
Total shareholder’s equity is the amount that shareholders have invested in the company plus its retained earnings.
Interest coverage ratio
The interest coverage ratio measures how many times a company can cover its current interest payment with its available earnings. A high interest coverage ratio indicates that the company can easily generate sufficient profit to pay interest on its outstanding debt.
EBIT = Earnings before interest and taxes
The equity multiplier is a measure of the portion of a company’s assets that is financed by shareholders’ equity rather than by debt. The equity multiplier is similar to the D/E ratio and replaces debt with assets in its numerator:
Debt of the company is accounted for and included in total assets. A high equity multiplier indicates that a company is using a large amount of debt to finance assets while a low equity multiplier signals a lower reliance on debt.
The equity multiplier is also a component of the DuPont analysis for calculating return on equity (ROE).
Degree of financial leverage
Degree of financial leverage measures the sensitivity of a company’s overall profitability to fluctuations in its operating income, as a result of changes in its capital structure. It reveals the level of volatility in the earning per share (EPS) due to capital restructuring activities, such as acquisition of debts, issuing of shares and debentures and leasing out assets.
Percentage change in EPS is measured against a unit change in earnings before interest and taxes (EBIT) and is represented as:
A higher degree of financial leverage means that even a small change in the company’s leverage has magnifying effects on returns, which results in a significant fluctuation in the company’s profitability, and is an indication of unstable earnings per share.
The above financial leverage ratios differ across industries and sectors. For instance, companies in the manufacturing sector usually have higher D/E ratios as they require higher capital expenditure to invest in machinery and other assets, as compared to companies in the service industry. Thus, it is recommended to measure and compare financial leverage ratios of a company against its past performance and with companies operating in the same industry for better analysis and benchmarking.
Examples of financial leverage
An example is given below to illustrate how financial leverage can positively or negatively impact a company’s return on investment, with regards to an asset purchase.
Company A and B wish to acquire an asset with an original cost of $1,000,000. Company A uses purely equity financing whilst Company B uses a mixture of 50% equity and 50% debt (financial leverage) to finance the purchase. With equity financing, there are no interest payments, whereas for debt financing, assume that the annual interest cost is at 5%.
If the asset can be sold for $1,500,000 a year from now (a gain scenario):
On the other hand, if the asset can only be sold for $500,000 a year from now (a loss scenario):
Effects of using financial leverage
There are several upsides and downsides to using financial leverage.
Financial leverage is a solid method to access capital. If managed properly, the amount of financial capital available at a company’s disposal will be boosted, and a higher rate of return on investment can be generated than with no leverage. Financial leverage is also useful for furthering short-term business growth objectives, such as engaging in acquisitions and to raise capital quickly and effectively. There are also benefits in terms of taxation, as interest costs are a form of deductible expense in calculating tax liability.
However, the risk of using financial leverage can be high, especially in loss scenarios where the asset fails to generate the expected returns and along with the additional burden of paying interest on debts. Failing to manage debt repayments can also lead to a worsening of credit ratings which potentially lowers a company’s reliability and future access to capital.
In summary, companies can rely on financial leverage as an economical means to fulfill its short-term needs for capital as long as proper risk management is applied to ensure the accompanying costs do not escalate beyond the control of the company.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.