What is financial leverage?
In business, leverage is the use of borrowed capital, usually in the form of corporate bonds or loans, to finance operations in order to generate revenue.
In order to grow in value, companies must hire, expand, conduct research, develop new products and services, purchase equipment, and lease warehouses and offices. If a company does not have enough cash to finance these activities, it must either issue additional shares or borrow money.
Businesses “leverage” borrowed capital by using it to generate revenue and increase the value of the business. The more money a business borrows, the more “leveraged” it becomes. Ideally, the income generated from the use of borrowed capital should exceed the cost of borrowing (i.e. interest payments). The more a company’s debt-generated income exceeds its cost of borrowing, the more effectively it uses leverage.
Why do companies use leverage?
When a company issues common stock to raise funds, it is giving up part of its ownership to shareholders. When a company issues corporate bonds or takes out a loan, on the other hand, it is able to invest in new projects without giving up ownership. When a company’s debt-financed investment pays off by increasing its revenue, the company’s return on equity (ROE) increases because it has not issued additional equity in order to increase his income.
How do companies use leverage?
When companies sell corporate bonds or take out loans, they do so to fund specific revenue-generating projects. As mentioned above, common uses for debt financing include hiring, purchasing assets like plants or equipment, research and development efforts, and even marketing. Additionally, debt financing can be used to acquire other businesses whose assets can be incorporated into the company’s revenue generation strategy.
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Example of financial leverage
An East Coast-based beverage company whose drinks were sold in stores and restaurants across the country could use leverage in the form of a business loan to finance the purchase of a new plant of beverage and canning production on the west coast to reduce the cost of transporting its inventory across the country.
By using a loan instead of issuing new shares, the company would not cede any additional ownership to shareholders. Ideally, the money saved on transportation should outweigh the cost of borrowing to buy the new plant in the long run, which would translate into increased revenue for the business and a higher return on equity.
How is financial leverage measured?
Most investors and analysts assess leverage using debt ratios, which express the degree to which a company’s operations or assets are financed with debt. Several leverage ratios exist, but the most popular is the debt ratio.
Popular leverage ratios used by investors
- Debt ratio (D/E): The debt-to-equity ratio (calculated by dividing a company’s total debt by its equity) is a great way to compare how much of what a company owns and does that is financed with borrowed money versus the hope that much of it is funded by investor money. .
- Debt to Total Assets Ratio: The debt-to-total-asset ratio (calculated by dividing a company’s total debt by the value of all of its assets) helps investors understand what percentage of a company’s assets (for example, factories, property , equipment and intangible assets such as goodwill and intellectual property) were financed with borrowed money.
- Rate of endettement : The debt-to-equity ratio (calculated by dividing a company’s total debt by its total capital) provides insight into a company’s capital structure by defining a company’s debt as a proportion of its total capital (c i.e. debt plus equity).
What is healthy leverage for a business?
In general, a debt-to-equity ratio of around 1 and a debt-to-total-asset ratio of around 0.5 could be considered “normal”. That being said, the degree of leverage considered healthy varies widely across industries, and some industries (e.g., banking) use leverage significantly more than others. For this reason, comparing the leverage ratios of an automotive company to those of an Internet company would not make much sense.
Within an industry, however, if a company is significantly more leveraged than its peers, it is likely a riskier investment because its potential to default is higher. A company that is significantly less leveraged than its peers, on the other hand, could be considered a safer investment within its industry.
When evaluating leverage, the age of the company is also an important factor. It’s normal for startups and young growth-stage companies to routinely fund many of their assets and operations with debt, so high debt ratios shouldn’t necessarily scare off investors when it comes to new, smaller-cap growth companies.