Financial leverage means any use of debts in financing a company’s operations.
It is the degree to which a company uses the money it has been lent, such as debt and preferred stock. It refers to the act of borrowing in order to acquire additional assets. If used correctly, this way of financing is often advised by some of the best accounting companies.
There is so much to be said on this topic. So, we compiled an easy-to-understand guide to leveraged finance, delving into some of the most important facts. Let’s see what we got here.
The Leverage Rule
The interest rate must be lower than the profit, or rather the rate of return that the company makes. If the profit is lower than the interest, the company goes bankrupt. This is called a leverage rule.
Leverage is a useful indicator that provides managers with information about how sensitive a company’s profitability is to changes in financial debt and capital in the balance sheet structure.
On the other hand, there is a situation in which the company’s profitability is balanced by borrowing, which results in the effect of leverage risk.
Let’s take a look at what leverage risk is.
The biggest risk of leveraged finance is the accumulation of losses.
Due to the impact of leveraged finance on solvency, a company that borrows too much money could face bankruptcy during a business crisis. In contrast, a less developed company could avoid bankruptcy due to greater liquidity.
A higher degree of use of financial leverage in the company’s operations generates the company’s economic structure, which is characterized by a higher share of fixed costs. In this way, there is a higher level of risk that the volume of business operations will not cover the burden of fixed costs.
Increasing the share of debt in capital creates greater financial leverage and thus greater business risk and a higher return on equity (ROE).
However, the higher the leverage, the higher the financial risk, and the level of indebtedness of a company can never be 100% because it is simply not acceptable to creditors.
When assessing leverage risk, it is also important to consider the company’s value and its activities.
For example, if a company borrows money to modernize, increase its product line, or expand internationally, further diversification is likely to offset the additional leverage risk. As a result, if added value is expected using leverage, the added risk should not harm the company or its investments.
If the value is added by financial leverage, then the associated risk will not be negatively affected.
When is leveraged financing profitable?
When it comes to borrowing, debt financing is profitable as long as the business achieves a rate of return higher than the cost of financing capital.
An indebted profitable company is more profitable than (the same) obligated company due to the influence of financial leverage.
If there is a drop in profitability, the company’s survival may be in question because external creditors prioritize collection over owners.
The positive impact of leverage finance
The positive impact of financial leverage is due to the degressive nature of fixed financing costs.
The increase in debt in the sources of financing, i.e., the interest that the company pays on debt, generates positive effects of leveraged finance since the unit fixed costs of financing decrease with the increase of the financial result.
This reduces the company’s total operating expenses, which affects the increase in the company’s value as a whole.
The negative impact of leveraged finance
The negative impact of leveraged finance is due to the increase in market interest rates that the company pays on debt.
Namely, the rise in debt in sources of financing, i.e., interest paid by the company on debt, generates negative effects of financial leverage since the stronger intensity of the use of obligations in financing the company’s operations implies additional risk premiums to creditors.
This increases the company’s total operating costs, which reduces the value of the company as a whole.
What should you pay attention to when leveraging?
Owners and management need to be aware of the level of leverage and its impact on business. They must be prepared to respond to both the growth and decline in revenue that awaits them in the future. This is the only way they can be secure in the survival and development of their society.
The helpful resources claims that companies which are using leverage finance have to tie their maturities to the main inflows.
At the ideal level of leverage finance, the return on a company’s capital increases because leverage increases stock volatility, increasing the level of risk that increases returns.