There are different ways for companies and individuals to finance funds for their operations and investments. One such powerful method is called financial leverage. With this approach, companies and individuals can borrow funds to grow or increase returns.
In this blog, we’ll learn the financial leverage meaning with some examples, look at the various ratios of financial leverage, understand the types of leverages financial management deals with, and see the benefits and drawbacks of financial leverage. Let’s get started!
What is Financial Leverage?
The technical financial leverage definition can be stated as a company’s approach of leveraging debt to optimise capital structure, maximise profitability, and facilitate business expansion without having to dilute the control and ownership of the existing shareholders.
However, financial leverage meaning can simply be understood as companies and individuals using borrowed funds to invest in assets that increase returns or profits. The goal of the borrower is to make sure that the profits generated by the newly acquired asset generate more earnings than the interest on the borrowed amount.
Understanding Leverage in Financial Management
An individual can increase returns on investments and a company can optimise its financial structure by making use of leverages in financial management. With borrowed funds, one can gain access to expensive assets that otherwise would have been out of reach of companies or investors. If managed wisely, these assets can then generate higher returns than the cost of borrowing, and increase the borrower’s profits.
Leveraging does however come with significant risks. Should the borrower be unable to pay the interest or the loan amount, it can lead to financial strain, reputational damage, loss of assets, and even bankruptcy. Investors and companies should always assess the viability and risks of leveraging before taking any loans. There are three major types of leverages financial management focuses on – financial leverage, operating leverage, and combined leverage.
Examples of Financial Leverage
Suppose Rahul wants to buy a second house as an investment. He doesn’t have the funds to buy one outright, so he decides to get a home loan that covers 65% of the house’s cost. He calculates that if he puts the house up for rent, he can cover the mortgage payments with the rental income, and still have some residual profit.
In this case, Rahul is using financial leverage by borrowing money (in the form of a home loan) to purchase an asset (the second house). The rental income generated from the house is expected to exceed the cost of borrowing (including interest), which increases Rahul’s overall return on investment. After he pays off the mortgage, Rahul will fully own the second house and continue to receive rental income, which will now contribute totally to his profit.
Let’s take a look at another financial leverage example. Suppose a company assesses that setting up a new plant could prove to be a great expansion opportunity, but it requires a huge capital investment. There are two ways the company can go about acquiring the required funds. The first option is to raise the necessary capital through equity financing, which means issuing new shares to investors. This would increase the company’s equity base and also help the company avoid the cost of borrowing, but it would decrease the control existing shareholders have over the company.
Its second option is to leverage its financial position by getting a loan from a bank or issuing corporate bonds. The new plant would increase production, and should everything go to plan, the company’s profits would exceed the interest payments. When the loans are paid off the company will benefit from this increased profitability. However, if the plant fails to generate expected returns for whatever reasons, the company could struggle to meet its loan obligations, and suffer financially.
Also read : 5 Tips to Leverage IPL Principles for Financial Success
Financial Leverage Ratio Formula
There are several ratios that can help you calculate the financial leverage of a company. Here are some of them along with the relevant financial leverage formula.
1. Debt to Equity Ratio
This ratio measures how much of the company’s funds are borrowed compared to the funds it has raised through shareholders. This financial leverage ratio formula is – Debt to Equity (D/E) = Total Debt / Total Equity. Hence a company with a debt to equity ratio of more than 1 has more debt compared to equity.
2. Debt to Capital Ratio
This ratio compares the company’s debt to its capital, that is, the company’s total debt and total equity. The formula of debt to capital ratio is – Debt to Capital = Total Debt / (Total Equity + Total Debt). This formula takes into account short, as well as long-term debt.
3. Interest Coverage Ratio
This ratio measures how effectively a company can meet its interest payments. Generally, companies try to keep this ratio over 3, but a good interest coverage ratio differs from industry to industry. It is calculated by – Interest Coverage Ratio = Operating Income / Interest Expenses.
4. Debt to EBITDA Ratio
EBITDA stands for Earnings Before Income Tax, Depreciation, and Amortisation. This ratio measures how much debt a company has relative to income generated by the company in a given period. Debt to EBITDA ratio is given by – Debt to EBITDA Ratio = Debt / EBITDA. The higher this ratio, the higher is the financial leverage.
5. Total Debt to Total Asset Ratio
WIth this ratio, one can calculate the proportion of a company’s assets that are financed by taking debt. This ratio is given by the formula – Total Debt to Total Asset Ratio = Total Debt / Total Assets.
6. Equity Multiplier
This ratio does not take debt directly into account. It measures how much of the company’s assets are financed by equity. The equity multiplier is calculated by – Equity Multiplier = Total Assets / Total Equity. If the equity multiplier is low, it means that the company’s assets are largely financed with equity.
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Types of Leverage in Financial Management
In financial management, there are three major types of leverage.
1. Financial Leverage
When individuals and companies use debt to finance investments, they are said to be employing financial leverage. They borrow funds to buy assets with the expectation that the income or profit from the investment will be more than the cost of interest and principal repayments.
2. Operating Leverage
Companies incur mainly two types of costs – fixed or variable. Fixed costs are independent of production, so whether the company makes a profit or loss, it has to pay the fixed costs. Operating leverage measures the proportion of the fixed costs in the cost structure of a company.
If a company has high fixed costs, it will have high operating leverage. If such a company increases its production and sales, the costs will mostly stay the same, while the profits will get a massive boost. However, if the sales go down due to demand or any other reason, the company would still need to cover its high fixed costs, which can lead to loss.
3. Combined Leverage
This type of leverage combines both operating and financial leverage, and represents the overall risk exposure of a company. It shows how fixed costs as well as debt impact a company’s profitability and risk.
Pros and Cons of Financial Leverage
| Pros of Financial Leverage | Cons of Financial Leverage |
| Loans can help companies and individuals get access to more expensive investment options that they otherwise wouldn’t have been able to get due to small starting capital. | Leveraging can be risky. If the investment for which money was borrowed does not work out, the company could face serious financial problems. |
| Companies can use borrowed money to expand and grow their operations, which helps in long-term profitability. | Just like financial leverage can increase profits quickly, it can also amplify losses in a short time. |
| Debt financing also prevents companies from issuing more shares, which helps in maintaining the ownership structure and control for existing shareholders. | Unlike equity financing, there is a cost of borrowing associated with financial leverage. Companies must repay the interest and principal amount on time, regardless of whether they earned a profit or not. |
| When used correctly, financial leverage can improve return on equity. | If the company defaults on payments, leverage can hurt its creditworthiness and market reputation. |
Conclusion
When used right, financial leverage can be a very powerful tool for companies to increase returns on investments and accelerate growth without having to dilute the control and ownership of the existing shareholders.
However, it does come with significant risks. If the company fails to generate more profits than the cost of borrowing, it can lead to financial trouble, reputation damage, and even bankruptcy. That’s why companies should assess the viability, profitability, and risks of their new investments before committing to debt financing.
FAQs on Financial Leverage
1. What is financial leverage in financial management?
When companies need to grow or expand, they need funds other than just profits. They can raise these funds by debt financing, which means borrowing money through loans, bonds, or other debt instruments.
Financial leverage refers to the use of this borrowed capital to increase the return on investment. The goal of a company is to make sure that the profits earned through these loans are more than the cost of borrowing the funds, i.e., interest.
2. Why Is Financial Leverage Important?
Financial leverage helps companies raise funds for investing, without having to issue more shares. This lets existing shareholders keep their level of control over the company, and also helps companies invest in assets that will help them generate more profits over the long term.
For example, a company may borrow some money to buy a new machine that reduces current costs and promises more output. However, unlike raising funds through equity, financial leverage comes with many risks.
3. What Is a Good Financial Leverage Ratio?
If the debt to equity ratio of a company is more than one, that means it has taken on more loans compared to its shareholder funds. The higher the ratio, the more debt in the company, which indicates high risk.
A good ratio varies by industry and company, so to judge if this ratio is good, you should compare the company to similar companies in the same industry or look at its past financial performance.
4. How do you calculate financial leverage?
There are many different ways of calculating financial leverage, such as debt to equity ratio (given by total debt divided by total equity), interest coverage ratio, debt to assets ratio, debt to capital ratio, and debt to EBITDA ratio.
5. What Is an Example of Financial Leverage?
An example of financial leverage is a company taking a bank loan to raise money for opening a new branch. If the company assesses the profitability of this expansion and comes to the conclusion that the profits they earn because of this new branch will exceed the cost of the loan, then using financial leverage has worked to its advantage.
But financial leverage comes with risks too. If the new branch does not perform as the company expects and the profits do not cover the loan costs, the company could face some serious financial trouble.
6. Why is financial leverage important in financial management?
Financial leverage allows the existing shareholders to keep their current level of control over the company as they can raise funds by taking out loans rather than issuing new equity. This avoids diluting shareholders’ ownership stakes.
Other than that, leveraging debt can help companies to expand and grow more quickly, and also help them acquire assets that are too costly for them to buy without financing.
7. What are the risks associated with financial leverage?
When companies borrow money to invest in new assets, they hope that the profits they generate will cover the cost of borrowing. The biggest risk companies take by doing this is the possibility that the new assets or projects won’t generate enough returns to cover the loan payments. This can hurt the credit rating, as well as the reputation of the company.
8. How does financial leverage impact a company’s capital structure?
The capital structure of the company tells us about the mix of debt and equity used to finance its operations. Financial leverage increases the proportion of debt relative to equity which can increase returns, but it does come with some risk.
9. What is the difference between operating leverage and financial leverage?
Operating leverage measures how a company’s fixed costs (meaning costs that are independent of the level of production) impact its profitability. If a company has a high operating leverage, it means that it has higher fixed costs. A change in the amount of sales can lead to big changes in operating income.
On the other hand, financial leverage is related to the use of debt to finance a company’s investments. It measures how much borrowed money a company uses to increase its returns. Simply, operating leverage focuses on the cost structure of operations, whereas financial leverage focuses on the capital structure of the company.
