There is no single financial leverage definition that captures all aspects of the ratio. However, it loosely refers to using debt to buy assets. An entrepreneur may use debt to buy an asset to help increase returns on its investment.
Typically, a company needs financial capital to run its activities. A business can raise such capital by selling its shares or issuing debt securities. Therefore, a company’s capital consists of two major components: owners’ equity and debts.
Financial leverage refers to how much-fixed assets such as stocks constitute the company’s capital structure. Good financial leverage should revolve around how a company’s assets are financed by owners’ equity and other debts.
A company with sufficient taxable income will shield its operating profits and is likely to reduce equity value and its net worth if it does not carefully select its sources of financing. As such, a company needs to look at its financial leverage to plan how it should run.
Read on to understand more about financial leveraging and how it is important to any business.
Financial Leverage: What It Means
Financial leverage meaning is defined as the extent to which a business utilizes its borrowed resources. A high leverage ratio is risky and indicates that the business risks going bankrupt if it cannot service its debt. The ratio may imply that the businesses will find it difficult to get new lenders in the future.
So, what is financial leverage? Is it bad for a business? Well, no, financial leverage is not always bad for a business. In fact, in some cases, it may increase shareholders’ return on investment. Also, it helps to leverage accounting and comes with tax advantages. These are the advantages that help to optimize the shareholder’s returns.
Thus, leveraging is a strategy which a business may use to increase return on its investment. Households can also use leverage to purchase a house since it boosts its purchasing power. They can also use it as bargaining power to buy more assets and take advantage of a situation to help generate more profits.
On the other hand, when a company is highly leveraged, it has more debt than its equity. However, if the return on the investment is higher than the rate of interest the company pays on loans, its leverage will reduce because the value of its assets will be increasing.
Therefore, just the same way physical leverage allows one to lift heavier objects than they can handle in a normal situation, financial leverage allows the business to buy more assets than they can afford. It enables businesses to borrow more money to run a business compared to other methods of borrowing: such as selling equities or the business assets and using the proceeds for business operations.
What Are the Different Kinds of Leverage?
There are three kinds of financial leverage example; Operating, Financial and Combined leverage.
- Financial Leverage
It is a management tool that managers use to maximize returns on the shareholder’s equity. Typically, a company’s assets are made up of owners’ equity, preference shares, and debenture. The assets may be purchased from long-term sources of funds and borrowings. But an intelligent business person should carefully select the sources of finances to maintain a good debt to equity ratio.
Notice that balancing the mix of debts is critical since it determines the expenses to be paid, the cost of interest and how it impacts the profits.
- Operating Leverage
We can classify costs as fixed and variable. Thus, the operating leverage will always affect the fixed costs. If a firm employs more fixed assets in producing goods and services, the operating costs will be high irrespective of the size of production. But when fewer fixed costs are incurred in the production process, operating leverage will be lower.
Therefore, operating leverage depicts how a firm can use operating costs to cause changes to sales, which increases its profitability. It shows how sales change as a result of changes in fixed operating income. A high amount of operating leverage shows a high amount of fixed costs which negatively impacts operating profit and increases these operating profits.
- Combined Leverage
It shows the relationship between changes in sales and variation in taxable income if a change in sales results in a bigger change in taxable income, then implementing such changes may not add value to the business.
How Financial Leverage Is Measured
You can measure financial leverage in many ways. However, the most common measures are:
- Debt ratio – it compares a business’s debts to total assets. It shows the value of the asset that is financed by debts.
- The debt-equity ratio compares the debt to the business equity. It shows how the owners’ equity finances the debt.
- Interest coverage ratio- it shows how the profits relate to interest. It simply shows how many times the available profit can pay off the debts. If the ratio is high, it depicts a high interest-paying capacity.
Risks of Financial Leverage
Financial leveraging is a risky affair since it multiplies losses. A company that engages in excessive borrowing faces bankruptcy during downturn times. So, when evaluating an investment strategy, you must evaluate the nature of the leverage you use.
Thus, financial leverage shows how the business is using borrowed funds to purchase its assets. The move can increase potential returns or potential losses.
An asset financed by borrowing should have a certain cash flow. If the cash flow is uncertain, it is risky and, thus, may result in larger losses. So, any prudent investor should seek assets with certain returns to help reduce risks.
When Do You Use Financial Leverage?
You may consider using financial leverage when the debt incurred can generate more returns than the expenses you pay servicing it. So instead of acquiring more equity capital that reduces the earning per share of the existing shareholders, a firm will be better off using financial leverage.
As a result, investors should only use leverage when they want to multiply their asset’s purchasing power. Also, they may use it when they want to finance their assets. For instance, it does not make sense to issue new stocks whenever a company wants funds to spend on business operations. Doing so reduces the shareholders’ value.
What Is a Good Financial Leverage Ratio?
A good financial leverage ratio should be less than 1. If it is more than that, it could be quite risky. Why? Because lenders will not want to associate with a company whose financial leverage ratio is greater than the aforementioned number. Note that when the ratio is higher than 2, it is an alarm and a major cause of concern. Therefore, an ideal leverage ratio may vary, but anything less than 1 is great.
But again, the financial leverage ratio varies and will depend on the specific ratio referred to. For instance, some ratios should always be high. Thus, a high-interest coverage ratio is better.
However, when the debt-to-equity ratio is below 1.0 it indicates that a business has a low debt compared to its equity. On the other hand, a ratio of 1.0 implies that the company’s equity and debt are the same. A ratio of about 0.5 is a good one and shows that the company’s assets are twice as much as its liabilities.
However, leverage in finance is always difficult. Further, a desirable finance leverage ratio is relative. So, it may not be easy to conclude that the ratio is good since its interpretation depends on many factors. Some of the most important factors are the size of the company, its scale of operation, the industry in which the firm is, and how mature the company is.
Overall, a firm should always strive to have a good combination of financial and operating leverage.