Alternatively, the company may go with the second option and finance the asset using 50% common stock and 50% debt. It means that if the company pays back the debt of $50,000, it will have $80,000 remaining, which translates into a profit of $30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000. This means that after paying the debt of $50,000, the company will remain with $20,000 which translates to a loss of $30,000 ($50,000 – $20,000).
Leverage is a problem when the cash flows of a business decline, since it then has difficulty making interest payments on the debt; this can lead to bankruptcy when it has a large debt load. This issue can be mitigated by restricting the amount of debt that a business takes on, as well as by maintaining a reasonable cash reserve. And considering how low interest rates are these days, it’s reasonable to expect that they will rise versus decline. Just as there’s a positive multiplier effect, there also can be a negative one. As an added bonus, the successful use of financial leverage may improve a firm’s credit rating.
Financial Leverage
Using debt financing from the loan, the company is able to hire two more employees, purchase top-of-the-line equipment, and contract a designer to create a billboard advertisement. A company that is “highly leveraged” has most of its capital structure made up mostly of debt. If investment returns can be amplified using leverage, so too can losses.
The correlation often presents itself more clearly when a business that leverages debt financing earns higher returns during periods of prosperity. For example, suppose a company with a 20% ROE decides to successful use of financial leverage requires a firm to increase its financial leverage. Let’s say the borrowed capital costs 8% in interest, but when invested, earns an ROE of 16%. DuPont analysis uses the equity multiplier to measure financial leverage.
Risk of Financial Distress
EPS increases only when the Return on Investment (ROI) is greater than the cost of debt. However, depending on your circumstances, it may be valuable for you to use financial leverage. Figuring out those circumstances can be difficult, which is why consulting with a financial advisor is of paramount importance. Acquisitions, buyouts, one-time dividends and share buybacks (i.e., situations with specific objectives) are all ideal for using financial leverage. In a related Q&A we illustrate how leverage can increase or decrease the returns on investments.
It raises its earnings per share by making use of fixed-cost securities or debt. If a company is “highly leveraged,” it means that it has more debt than equity. If the loan is backed by assets, then the lender uses assets as collateral until the loan is repaid. In the case of a cash flow loan, the creditworthiness of the company is used to back the loan.
Advantages of Using Financial Leverage
One can calculate the equity multiplier by dividing a firm’s total assets by its total equity. Once figured, multiply the total financial leverage by the total asset turnover and the profit margin to produce the return on equity. However, reckless use of trading on equity is not advised even when the return on investment is greater than the cost of debt. An increase in debt may enhance the earnings per share but also raise the financial risk.
The most obvious indicator of too much leverage is an inability to pay off debts. If a company defaults on its lending agreements, it has leveraged too much debt. For example, Uber leverages supply and demand in order to fuel its business model. In 2019 fintech trends, European banks are leveraging data to innovate the industry.
Financial leverage significantly impacts a company’s corporate social responsibility (CSR) initiatives. It does so by determining the available funding for social and sustainable projects. Companies with high financial leverage often allocate a significant part of their profits to repayment obligations, reducing the funds available for CSR activities. Suffice to say, financial leverage has a key role in corporate finance, helping businesses expand, innovate and align their capital structure to their overall strategic goals.