Using debt to acquire more assets is known as financial leverage. It is used to enhance the return on equity by using leverage. On the contrary, high financial leverage raises the risk of failure since repayment of debts becomes more difficult.
The ratio of total debt to total assets is used to calculate financial leverage. The level of financial leverage grows as the ratio of debt to assets increases. As long as the gains from borrowing exceed the interest costs connected with borrowing, financial leverage is a good thing to have. Rather of raising new equity capital, many firms rely on financial leverage, which might lower the earnings per share of current owners
Increased volatility of a company’s stock price is produced by exceptionally significant swings in earnings induced by a high level of leverage. As a result, stock options granted to workers might produce a larger compensation expenditure than less volatile shares.
Since sales and earnings are more likely to fluctuate from year to year in a cyclical firm with low barriers to entry, financial leverage is a particularly hazardous strategy. Leverage may be an acceptable choice in industries with stable revenue levels, substantial cash reserves, and strong barriers to entry since operational circumstances are stable enough to support a considerable degree of leverage with no downside.
Leverage has a natural limit since lenders are less willing to lend to a borrower who has already taken on a big amount of debt.
If cash flows don’t meet expectations then financial debt might lead to a company’s demise.
Using of Financial Leverage
For a firm to be successful, it must have access to financial capital. Debt securities and common stock are the most popular methods of raising financial capital for most organizations today. An organization’s capital structure is composed of debt and equity that have various risk and return implications. In order to arrive at a company’s desired capital structure, like it’s shown here, corporate management must go through a rigorous and cautious procedure. To what degree does a company’s capital structure employ fixed-income instruments and preferred stock? To be clear, financial leverage will diminish equity value and thus the worth of the firm if the company does not have enough taxable revenue to protect or if its operational profits are below a key threshold.
First, a company’s management must assess how much external money it needs to run its business, given the relevance of its capital structure. It is then up to management to look at the financial markets and assess how much cash can be raised. Because the market climate may limit the company’s capacity to issue debt instruments or common stock at an acceptable level of cost, this stage is critical.
The management of a firm may then establish an acceptable capital structure strategy and create a bundle of financial instruments to be offered to investors once these issues have been resolved. These steps ensure that management’s financial decisions are implemented in accordance with its long-term strategic strategy and how it plans to expand the firm over time.
Typical examples are retail businesses, airlines, supermarket stores, utility corporations, and financial institutions
What is the impact of Financial Leverage?
Using a simple example may be the most effective method to show the positive impact of financial leverage on a company’s financial performance. ROI is a widely used metric for assessing profitability since it compares the company’s earnings in a fiscal year to what shareholders have invested.
All businesses want to maximize shareholder wealth, and ROE is a measure of shareholder return on investment.
In order to increase shareholder profits, financial leverage is utilized as a tool. For example, it assumes that firms may get cash for fixed charges and costs for less than the rate of return on their assets.
Investing in assets funded by fixed-cost funds will result in higher returns for equity owners without raising their own investment.
Stockholders’ return on equity is often greater than the economic return ratio, and so leverage plays an essential role in helping to meet investors’ expectations about the return on equity. The impact of increased debt on common shareholders’ profits per share is used to assess financial leverage as a result.
Understanding Financial Leverage
The easiest way to grasp the concept of financial leverage is through your house mortgage. However, for financial leverage to be advantageous, it must fulfill two essential criteria. To avoid repossession, the borrower must be able to make payments. Another factor affecting leverage is whether or not an asset is worth what it is worth. The return on investment increases if the asset appreciates, whereas it decreases if the asset depreciates. If these two requirements are not met, leverage becomes unfavorable.
The failure to repay hazardous loans forced several of these firms, such as Orion Pictures and Live Entertainment to file for bankruptcy. If a firm wants to utilize leverage effectively, it needs accurate predictions, solid management judgments, common sense, and an unbiased assessment of the risks.
Unfortunately, most people are overly enthusiastic about leverage’s capacity to enhance profits without considering the obligations they may have to repay if the strategy doesn’t work out. It’s either they hit the ground running and become the new phenomenon in town, or they start slowly and establish their reputation as more people become aware of their exceptional service delivery. In spite of this, borrowing raises a company’s fixed costs of operation. Identifying possible hazards is crucial to ensuring that borrowed money is used effectively in the long run.
Financial Leverage Risk Measurement
Short-term liquidity ratios and long-term capitalization ratios are commonly used by corporate management to gauge financial leverage.
Since inventory isn’t included in the current assets, the acid-test ratio gives a better evaluation of the company’s current assets for the purposes of satisfying its current liabilities commitments.
They are also used to measure the amount of debt a company has.
Two of the most common capitalization ratios are the long-term debt to capitalization ratio and total debt to capitalization ratio. Financial leverage can also be measured using these ratios. Although it is possible to skew the ratio if the company’s management leases its assets without capitalizing their worth on the balance sheet. A company’s management may also choose to employ short-term debt to pay both short- and long-term capital needs in a low-interest-rate environment. In addition, the interest coverage ratio is essential since it demonstrates a company’s capacity to generate enough pre-tax operating income to pay the cost of its debt obligations.
Additionally, the ratio of money from operations to total debt and free operational cash flow to total debt are significant risk measures utilized by management.
Establishing a company’s financial structure requires careful consideration of a wide range of quantitative and qualitative criteria. An organization that has high and consistent sales is better positioned to use financial leverage than one that has lower and more variable revenues.
As for business risk, a firm with less operational leverage tends to be better equipped to take on more financial debt than one with higher operating leverage.
Third, fast-growing firms are more prone to rely on financial leverage since they require more cash than their slower-growing rivals.
Fourth, a firm with a higher tax rate tends to borrow more in order to benefit from the interest tax shield.
Less profitable companies tend to utilize higher financial leverage since they are generally not in a strong enough position to support their business operations with their own cash.
Examining a wide range of internal and external issues can also be helpful in making a capital structure selection. From a management perspective, firms with aggressive CEOs tend to utilize greater financial leverage than those without. Therefore, their goal in utilizing financial leverage is not just to improve the firm’s results, but also to assist them to maintain control of the organization.
Stocks and bonds can also be issued in good times to raise cash. As a result of difficult economic circumstances, lenders of capital tend to choose a secured position, which in turn emphasizes the usage of borrowed capital. So, management prefers to organize capital composition in a way that will allow future capital raising flexibility in a constantly changing market environment.