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 refers to the practice of using borrowed funds to purchase assets, aiming for returns or capital gains that exceed the borrowing costs. Lending institutions typically impose limits on the extent of leverage they allow, depending on the borrower’s risk profile. For asset-backed loans, the borrowed funds are secured against the asset itself, while for cash flow loans, the borrower’s creditworthiness serves as collateral.
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.
How financial leverage works?
When acquiring assets, a company has three primary financing options: equity, debt, and leases. While equity financing does not incur fixed costs, both debt and lease financing involve fixed obligations. These fixed costs are typically lower than the income the company anticipates generating from the acquired asset.
For instance, if a company opts to use debt to finance its asset purchase, it borrows funds with the expectation that the returns from the asset will exceed the interest payments on the debt. This approach allows the company to amplify its earnings potential without committing substantial equity capital. However, the success of financial leverage hinges on the company's ability to manage its fixed costs and generate consistent income from the financed asset.
Example of financial leverage
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.
Financial Leverage Ratio Formula
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.
1. 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:
Debt-to-equity ratio = Total debt ÷ Total equity |
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.
2. 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:
Interest coverage ratio = EBIT ÷ Interest expenses |
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.
3. 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:
Debt-to-EBITDA ratio = Debt ÷ EBITDA |
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.
4. 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:
Debt ratio = Total debt ÷ Total assets |
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.
5. 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:
Debt-to-capital ratio = Total debt ÷ (Total debt + total equity) |
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.
Advantages and disadvantages of financial leverage
Financial leverage offers opportunities for growth and profit but comes with inherent risks.
Advantages
- Amplified returns: Leverage allows investors to maximise profits by enabling them to make larger trades or investments than their initial capital permits.
- Access to capital: Businesses can use leverage to fund acquisitions or execute growth opportunities that require significant upfront capital.
- Short-term gains: In controlled situations, such as acquisitions, leverage can provide the necessary funds for a growth opportunity, leading to long-term success if used responsibly.
- Strategic usage: Companies can leverage funds for specific objectives, ensuring the borrowed money is employed strategically for optimal returns.
Disadvantages
- Higher risks: While profits can be magnified, losses can also exceed the initial investment, exposing investors to significant financial risks.
- Added costs: Fees, interest rates, and margin requirements from brokers increase the cost of leveraged positions.
- Complexity: Managing leveraged investments requires careful monitoring and a thorough understanding of financial risks, making it unsuitable for inexperienced investors.
- Potential for loss: When market conditions turn unfavourable, the borrower may face additional liabilities or forced liquidations.
Risks of financial leverage
Although financial leverage can drive higher profits, it can also lead to severe financial strain under certain conditions:
- Disproportionate losses: When returns from leveraged assets fail to cover borrowing costs, the borrower faces increased financial burdens, particularly during asset value declines or rising interest rates.
- Volatility in stock prices: High leverage often results in significant profit fluctuations, leading to erratic stock price movements and challenges in valuing employee stock options.
- Bankruptcy risk: Industries with low entry barriers face revenue fluctuations, increasing the likelihood of businesses defaulting on their debt obligations and risking insolvency.
- Reduced borrowing capacity: Companies with high debt-to-equity ratios struggle to secure additional funding. If lenders agree, the loans often come at elevated interest rates to compensate for the risk of default.
Difference between operating leverage and financial leverage
Category |
Financial leverage |
Operating leverage |
Meaning |
Utilising borrowed capital to boost returns and reduce taxes. |
Leveraging fixed costs to enhance returns. |
Measurement |
Assesses financial risk within the company. |
Evaluates operational risks of the organisation. |
Impact |
Greater leverage implies higher financial risk. |
Higher operating leverage indicates greater operational risk. |
Preference |
Widely preferred for growth opportunities. |
Less commonly prioritised. |
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.
