What is Financial Leverage

Companies have different sources of funds to choose from to facilitate growth and expansion. While equity is one common option, financial leverage is another. In this article, we define financial leverage, decode how to analyse it using different ratios and examine its pros and cons.

What is financial leverage

Financial leverage is the process of using borrowed money or debt to fund business investments, expansions, and other projects. The funds borrowed using financial leverage are typically invested into the company for fuelling growth. Alternatively, some businesses also use financial leverage as an investment technique to purchase different assets that could offer potential gains if their value appreciates.

Understanding leverage in financial management

Leverage in financial management is often misunderstood by beginner investors and traders. To break it down, companies can use any of three available channels to fund asset purchases and growth — equity, debt or leasing. Equity involves issuing shares to investors and diluting the company’s ownership. A lease is more like renting an asset and paying for its usage in instalments.

However, debt involves borrowing money from lending institutions and utilising those funds to secure the assets or complete the projects as needed. The money borrowed is repaid along with interest over a specific period as decided in the terms of the loan agreement. This is what financial leverage is all about.

Financial leverage can also be useful for individuals. For instance, investors tend to rely on this kind of leverage to take large positions in the market using relatively less capital. Such leveraged trading is commonly practised in options and futures trading.

Let us discuss an example to understand financial leverage better.

• Financial leverage for businesses: Say that a company has raised Rs. 1 crore via equity share issues and borrowed Rs. 50 lakh via loans. It now has funds worth Rs. 1.5 crore to invest in assets, fund its projects and fuel growth. Of this Rs. 1.5 crore, the Rs. 50 lakh that the company has borrowed makes up its financial leverage.
• Financial leverage for individuals: Say your stockbroker offers 4X margin funding. This means you can buy shares worth Rs. 4 lakh with just Rs. 1 lakh of your own capital. While you will have to pay interest on the amount borrowed (i.e. the additional Rs. 3 lakh), you can still take a much larger position in the market due to the added financial leverage.

Ratios used to assess financial leverage

To evaluate the amount of financial leverage in a company’s books and to assess if this could be beneficial or detrimental to investors, we have several financial ratios that can help. Here are the top ratios used to assess financial leverage.

Debt-to-Equity (D/E) ratio:

The D/E ratio compares the amount of money a company has raised through financial leverage or debt with the funds raised through the issue of equity shares. Its formula is as follows:

A D/E ratio of more than 1 indicates that the company has more debt than equity. The higher the number is, the more the company’s financial leverage is considered to be. To assess if a company’s D/E ratio is normal, you must compare the company’s debt-equity metrics with its peers and the industry at large.

Interest coverage ratio:

The interest coverage ratio tells you if a company earns enough (before deducting interest and taxes) to repay the interest due on the debts it is servicing. In other words, it compares the Earnings Before Interest and Taxes (EBIT) with the company’s interest expenses. This gives us the following formula:

The higher the interest coverage ratio, the better it is because it indicates that the company has enough earnings to meet the cost of its borrowings.

Debt-to-EBITDA ratio:

This ratio compares a company’s debts with its Earnings Before Interest, Taxes Depreciation and Amortisation (EBITDA). It analyses how much of the company’s income is available to repay its debts before it pays for its operating costs. The formula for this ratio is fairly straightforward:

A high debt-to-EBITDA ratio means that the company’s earnings are far less than its debt. If this ratio is less than one, it indicates that the company’s EBITDA is not enough to cover its debts even once.

Total debt to total assets ratio:

Also known as the debt ratio, this metric tells you how much a company relies on financial leverage. The formula used to compute this ratio is as follows:

A debt ratio of 1 means that the company’s debts and assets are equally matched. Ideally, investors must look for companies with a lower debt ratio because that means the company’s assets are higher than its debts, signifying less reliance on financial leverage.

Debt-to-capital ratio:

This is another straightforward ratio used to assess the financial leverage of a company. True to its name, the ratio compares the total debt of a company with its total capital. The formula for this is as follows:

It tells you how much of a company’s capital is financed by its debt. The higher this ratio, the more the company’s financial leverage.

Benefits and limitations of financial leverage

Like all financial decisions, financial leverage also comes with its upsides and limitations. The benefits of financial leverage include:

• Immediate availability of funds
• Increased shareholder value
• Improved returns on assets
• No equity dilution

However, financial leverage also has some risks or limitations, as outlined below:

• Potential damage to credit score if the borrowing is not repaid

• No guarantee of return on investments or purchases made using borrowed funds

• Risk of over-leverage

Conclusion

Ultimately, financial leverage is a crucial concept for both investors and businesses. If you are planning to invest in a company over the long term, it is essential to study the company’s financial leverage and evaluate if the company is capable of servicing its existing debts. An over-leveraged company may be a risky investment.