Financial leverage definition
/What is Financial Leverage?
Financial leverage is the use of debt to buy more assets. This is done in the expectation of a return on the purchased assets that will offset the interest cost of the debt. Thus, leverage is employed to increase the return on equity. However, an excessive amount of financial leverage increases the risk of failure, since it becomes more difficult to repay debt if the associated assets do not generate a sufficient return.
As the proportion of debt to assets increases, so too does the amount of financial leverage. Financial leverage is favorable when the uses to which debt can be put generate returns greater than the interest expense associated with the debt. Many companies use financial leverage rather than acquiring more equity capital, which could reduce the earnings per share of existing shareholders.
Lenders will put a cap on the amount of debt they are willing to grant. For example, they may use the assets being purchased by the borrower as collateral on their debt, so the amount of assets that can be purchased naturally limits the amount of debt that can be incurred. Or, if the owners are guaranteeing the debt, then the lender will only lend as much debt as the guarantors can be expected to pay back from their personal resources.
How to Calculate Financial Leverage
The financial leverage formula is measured as the ratio of total debt to total assets (also known as the debt-to-equity ratio). The debt figure in the numerator of the calculation represents all debt currently outstanding, including short-term loans, long-term loans, and lease commitments. The equity figure in the denominator of the calculation represents all equity items appearing on a firm’s balance sheet, including its common stock, preferred stock, additional paid-in capital, and retained earnings.
Example of Financial Leverage
Able Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual profits. The company is not using financial leverage at all, since it incurred no debt to buy the factory.
Baker Company uses $100,000 of its own cash and a loan of $900,000 to buy a similar factory, which also generates a $150,000 annual profit. Baker is using financial leverage to generate a profit of $150,000 on a cash investment of $100,000, which is a 150% return on its investment.
Baker's new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its original investment.
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Advantages of Financial Leverage
Financial leverage has two primary advantages First, it can enhance earnings as a percentage of a firm’s assets. Second, interest expense is tax deductible in many tax jurisdictions, which reduces the net cost of debt to the borrower. The result can be a substantial increase in earnings, leveraged off the money provided by lenders.
Disadvantages of Financial Leverage
Financial leverage also presents the possibility of disproportionate losses, since the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is a particular problem when interest rates rise or the returns from assets decline. The same issue arises for an investor, who might be tempted to borrow funds in order to increase the number of securities purchased. If the market price of the security declines, the lender will want the investor to repay the loaned funds, possibly resulting in the investor being wiped out.
When to Use Financial Leverage
It makes the most sense to use financial leverage when there is an expectation of generating extremely consistent cash flows. When this is the case, it is easier to forecast the amount of cash that will be available to make debt payments. Consistent cash flows are more common in industries where there is a reduced level of competition, barriers to entry are high, and there is little disruption due to product innovation.
Stock Volatility Effects
The unusually large swings in profits caused by a large amount of leverage increase the volatility of a company's stock price. This can be a problem when accounting for stock options issued to employees, since highly volatile stocks are considered to be more valuable, and so create a higher compensation expense than would less volatile shares.
Financial leverage is an especially risky approach in a cyclical business, or one in which there are low barriers to entry, since sales and profits are more likely to fluctuate considerably from year to year, increasing the risk of bankruptcy over time. Conversely, financial leverage may be an acceptable alternative when a company is located in an industry with steady revenue levels, large cash reserves, and high barriers to entry, since operating conditions are sufficiently steady to support a large amount of leverage with little downside.
There is usually a natural limitation on the amount of financial leverage, since lenders are less likely to forward additional funds to a borrower that has already borrowed a large amount of debt.
In short, financial leverage can earn outsized returns for shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations.
Terms Similar to Financial Leverage
Financial leverage is also known as leverage, trading on equity, investment leverage, and operating leverage.