A lot of companies utilize financial leverage through the course of everyday business.
And while financial leverage comes with specific advantages depending on the goal of the company or individual and the individual/company itself, it has its disadvantages.
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| How Financial Leverage Works?: eAskme |
This article will talk about what financial leverage is, how financial leverage works, and how it is measured.
What is Financial Leverage?
Financial leverage is the use of debt or borrowed money to fund the purchase or acquisition of assets.
This is with the expectation that the capital gained or income generated from the acquired asset will outdo the borrowing cost.
In most situations, the provider who offers the debt limits how much risk they are willing to take.
Hence, they specify the limit on the degree of leverage they will allow.
In the case of asset-backed lending, the provider obtains the assets as collateral until the loan is being repaid.
Regarding cash flow loans, the company uses its general creditworthiness as collateral for the loan.
Now let's look at how financial leverage works and how it can be measured effectively.
How Financial Leverage Works?
When buying an asset, companies have three available financing options:
- Debt
- Leases
- Equity.
Aside from equity, the other two options incur fixed costs that are lower than the expected income the company projects to earn from the asset.
Therefore, in this kind of situation, it is believed that the company uses debt to finance the acquisition of assets.
Example :Assuming Company X wants to purchase an asset worth $100,000. The company can either finance the purchase using either debt or equity financing. If the company decides to use equity financing, it will have full ownership of the asset with zero interest on payment. Considering the asset appreciates by 30%, the asset will be valued at $130,000, and the company earns a profit of $30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000, and the company incurs a loss of $30,000.
On the other hand, the company opts for debt financing and decides to finance the purchase using 50% debt and 50% common stock.
If the asset appreciates by 30%, the asset's value then increases to $130,000. It implies that if the company pays back $50,000, it will have $80,000 left, translating to a profit of $30,000.
Consequently, if the asset depreciates by 30%, its value decreases to $70,000. This implies that after paying $50,000, the company is left with $20,000 translating to a loss of $30,000.
How to Measure Financial Leverage?
Debt-to-Equity Ratio:
The debt-to-equity ratio is used to calculate or measure the percentage of financial leverage of an entity.
The debt-to-equity ratio indicates the amount of debt to the company's equity.
It assists the company's lender, management, stakeholders, and shareholders in understanding the risk level in the company's capital structure.
The debt-to-equity ratio indicates the possibility of the company borrowing to face problems in meeting up with its debt commitments.
It also shows whether the leverage levels are healthy or not. The debt-to-equity ratio is calculated using the formula;
D/E = Total Debt / Total Equity
Here, Total Debt indicates the company's present liabilities (debt the company wants to pay within a year or less) and long-term liabilities (debt with
Here, Total Equity indicates the shareholder's equity plus the company's secured earnings.
Other Leverage Ratios:
Other types of common leverage ratios used to calculate financial leverage include:
- Debt to Capital Ratio
- Interest Coverage Ratio
- Debt to EBITDA Ratio
Even though the Debt to Equity Ratio is the most commonly used type of leverage ratio, the other three ratios stated above are also frequently used in corporate finance to calculate and measure a firm's leverage.
Conclusion:
Financial leverage is a great financial tool companies can effectively use to grow and expand their businesses.
However, as much as financial leverage offers great advantages when overused, it can ruin a business and render it bankrupt.
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