by Financial leverage is the use of debt to buy more assets. Leverage is employed to increase the return on equity. However, an excessive amount of financial leverage increases the risk of failure, since it becomes more difficult to repay debt.
The financial leverage formula is measured as the ratio of total debt to total assets. As the proportion of debt to assets increases, so too does the amount of financial leverage. Financial leverage is favorable when the uses to which debt can be put generate returns greater than the interest expense associated with the debt. Many companies use financial leverage rather than acquiring more equity capital, which could reduce the earnings per share of existing shareholders.
Financial leverage has two primary advantages:
- Enhanced earnings
Financial leverage may allow an entity to earn a disproportionate amount on its assets.
- Favorable tax treatment
In many tax jurisdictions, interest expense is tax deductible, which reduces its net cost to the borrower.
However, financial leverage also presents the possibility of disproportionate losses, since the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is a particular problem when interest rates rise or the returns from assets decline.
The unusually large swings in profits caused by a large amount of leverage increase the volatility of a company’s stock price. This can be a problem when accounting for stock options issued to employees, since highly volatile stocks are considered to be more valuable, and so create a higher compensation expense than would less volatile shares.
Financial leverage is an especially risky approach in a cyclical business, or one in which there are low barriers to entry, since sales and profits are more likely to fluctuate considerably from year to year, increasing the risk of bankruptcy over time. Conversely, financial leverage may be an acceptable alternative when a company is located in an industry with steady revenue levels, large cash reserves, and high barriers to entry, since operating conditions are sufficiently steady to support a large amount of leverage with little downside.
There is usually a natural limitation on the amount of financial leverage, since lenders are less likely to forward additional funds to a borrower that has already borrowed a large amount of debt.
In short, financial leverage can earn outsized returns for shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations.
Financial Leverage Example
Able Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual profits. The company is not using financial leverage at all, since it incurred no debt to buy the factory.
Baker Company uses $100,000 of its own cash and a loan of $900,000 to buy a similar factory, which also generates a $150,000 annual profit. Baker is using financial leverage to generate a profit of $150,000 on a cash investment of $100,000, which is a 150% return on its investment.
Baker’s new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its original investment.
Similar Terms
Financial leverage is also known as leverage, trading on equity, investment leverage, and operating leverage.
Leverage Ratio
A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obligations. The leverage ratio category is important because companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.
What Does a Leverage Ratio Tell You?
Too much debt can be dangerous for a company and its investors. However, if a company’s operations can generate a higher rate of return than the interest rate on its loans, then the debt is helping to fuel growth in profits. Nonetheless, uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too few debts can also raise questions. A reluctance or inability to borrow may be a sign that operating margins are simply too tight.
There are several different specific ratios that may be categorized as a leverage ratio, but the main factors considered are debt, equity, assets, and interest expenses.
A leverage ratio may also be used to measure a company’s mix of operating expenses to get an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ.
Finally, the consumer leverage ratio refers to the level of consumer debt as compared to disposable income and is used in economic analysis and by policymakers.
Banks and Leverage Ratios
Banks are among the most leveraged institutions in the United States. The combination of fractional-reserve banking and Federal Deposit Insurance Corporation (FDIC), protection has produced a banking environment with limited lending risks.
To compensate for this, three separate regulatory bodies, the FDIC, the Federal Reserve and the Comptroller of the Currency, review and restrict the leverage ratios for American banks. This means they restrict how much money a bank can lend relative to how much capital the bank devotes to its own assets. The level of capital is important because banks can “write down” the capital portion of their assets if total asset values drop. Assets financed by debt cannot be written down because the bank’s bondholders and depositors are owed those funds.
Banking regulations for leverage ratios are very complicated. The Federal Reserve created guidelines for bank holding companies, although these restrictions vary depending on the rating assigned to the bank. In general, banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios.
There are several forms of capital requirements and minimum reserve radios placed on American banks through the FDIC and the Comptroller of the Currency that indirectly impacts leverage ratios. The level of scrutiny paid to leverage ratios has increased since the Great Recession of 2007-2009, with the concern about large banks being “too big to fail” serving as a calling card to make banks more solvent. These restrictions naturally limit the number of loans made because it is more difficult and more expensive for a bank to raise capital than it is to borrow funds. Higher capital requirements can reduce dividends or dilute share value if more shares are issued.
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