What is Financial Leverage? How Does it Affect a Business?
Leverage is a strategy used by companies to increase its assets and cash flow and it also plays a significant role in identifying the losses, thereby, magnifying profits.
In finance, It is used as a funding source. For example, in a firm, it is used to expand its asset base and also to be able to generate returns on the risk capital.
Leverage is majorly employed for increasing returns on equity.
It also refers to the amount of debt a firm uses on financial assets. Whereas, financial leverage is also known as the trading of equity. Financial leverage is the use of debt or borrowed money to finance the purchase of assets.
This article will explain what financial leverage is, how to calculate financial leverage and how it affects the business.
Importance of Financial Leverage for a Business
Financial leverage is increased when a firm borrows capital after issuing fixed-income securities to money lenders. In some cases of asset-backed lending, the moneylender uses the assets as a collateral until the borrower pays it back.
The primary objective of introducing leverage is for shareholders/ investors to achieve maximum wealth.
The introduction of debt into the capital structure does not affect the sales and operating profit. However, it will affect the equity, return on equity, and the shareholders.
How is Financial Leverage Calculated?
Finacial leverage can be calculated through the following methods.
1. Debt-to-Equity Ratio
This ratio determines the amount of financial leverage.
In other words, it states how many portions of debt and equity are used to finance the company’s assets. The debt-to-equity ratio is calculated as below:
Total debt here refers to the company’s current liabilities (debt that the company intends to pay within one year or less) and long-term liabilities.
The total equity refers to the shareholder’s equity (the amount that shareholders have invested in the company), plus the amount of retained earnings (the amount included from its profit).
2. Debt Ratio
It is a ratio denoting the debt to the total asset of the firm. You can use it to measure a company’s leverage.
If the debt ratio is more than 1%, it indicates the company has more debt than assets. The debt ratio tells us that higher the ratio, the more leveraged a company is.
It implies a greater financial risk. Leverage is actually one of the most helpful tools for a company to grow. Capital-intensive businesses such as utilities and pipelines have much higher debt ratios when compared with the other industries.
The formula is:
3. Interest Coverage Ratio
Also known as the ‘Times-Interest-Earned’, ‘Interest Coverage Ratio’ measures the capability of a company to pay off interest expenses on its outstanding debt.
The formula uses the interest expense as debt and EBIT as a profitability measure. Interest Coverage Ratio is calculated as below:
Where EBIT=Earnings before interest and taxes
How does Financial Leverage Affect a Business?
Leverage means borrowing funds to finance inventory, equipment, or other assets. Industry uses leverages to purchase the asset, instead of using its equity.
When business owners need to acquire an asset and do not have cash, they either opt for debt or equity to finance the purchase.
When debt increases, the risk of being bankrupt increases, but here an advantage is that if the leverages are managed well, it will increase its profit and efficiency.
3. Cost of Debt
The cost of acquiring debt is the ordinary interest that you pay to the lender.
Upon obtaining a loan or any form of debt, businesses pay interest on the outstanding amount of debt.
This negatively affects profit, as the interest reduces the profit margin. However, if the cost of debt is kept lower than the profit or revenue generated, it positively impacts the business.
4. Restriction on New Investment Opportunities
High financial leverage implies that the company already has a lot of debt for which it will have to maintain a certain amount of cash flows to meet regular expenses of the cost of debt.
When there are restrictions on the usage of cash flows, businesses will also miss out on new investment opportunities.
5. Increased Profit Share
While companies obtain debt to finance their expansion, it allows their present owners to get better profits in the future.
However, if the company selects equity financing, then the future profit gets distributed among current and new investors.
How Does Financial Leverage Work?
There are three options available to a company to finance purchasing an asset.
The options are:
Debt and leasing are the two options that incur a fixed cost.
Let us understand this with an example.
A company wants to expand its business operations.
The company has two options to finance the expansion amount: issuing equity capital or obtaining a debt.
However, the company wants to analyze how financial leveraging will impact its return on investment. Let us compare the two options with an example:
Amount Needed for Business Expansion: INR 500,000
Option 1: Raise Equity Share Capital of INR 500,000
Option 2: Obtain a Loan of INR 500,000 @ 8% Interest
|Cost of Debt (Interest)
8% on 20,00,000
|Net Profit Before Tax
|Income Tax @ 30%
|Profit after Tax
|Net Profit available for Equity Shareholders
|Existing Equity Share Capital
|Equity Share Capital Raised
|Total Equity Share Capital
|Return On Equity
As seen in the above example, when a company plans to raise money by issuing equity share capital, it avoids the cost of debt, and the financial leverage is favorable on the lower side.
However, it loses the return generation capacity on equity.
Similarly, when a company plans to obtain a loan to finance its business expansion, it may result in cash flow limitations and an additional cost of debt. Still, the return on equity is much higher even though the financial leverage ratio is higher.
A firm operating on both financial leverage and operating leverage has high risk in debt and investing.
The most significant risk arises when a firm or a company’s return on asset does not exceed the interest on the loan in financial leverage, which diminishes the company’s profitability.
In contrast, a balanced financial leverage ratio offers an opportunity to increase the return on equity.