The other name of financial leverage is trading on equity or simply leverage. It indicates to the use of debt to have an additional asset in the business. With financial leverage, the following can be said.
- If there is an increase in the value of assets, it will result in a gain of the owner. In such a case, the loan interest would be less compared to the rate seen in asset value.
- It also results in a fall in the value of the asset that, in turn, has a greater impact on the owner’s cash.
What do you Understand by Financial Leverage?
Financial leverage is used to improve the company’s production, earning, and overall sales with the help of borrowed money. For calculation, you have to measure the ratio of total debt with a ratio of total assets. With greater debt, the level of financial leverage would also increase.
Higher leverage rates can prove to be beneficial for the company as it would help the company to flourish. On the other hand, it can also result in cash flow issues at the time of recession. But at the same time, the company should have enough funds available that would help to cover up for the interest payments of the company.
How does Financial Leverage Works?
For buying business assets, equity, leases, and debt are important to have. Other than equity, leases, and debt involve fixed costs. This cost is much lower when compared with the income rate that the company wishes to get from the assets mentioned above. Therefore, it can be said that the company uses debt to buy business assets.
How Does Financial Leverage is measured?
The debt to equity ratio can be used to measure financial leverage. The financial leverage would be measured in respect of the equity of the company. Therefore, this calculation gives a clear picture of the capital structure of the firm. This makes it easy for shareholders, lenders, and company’s management, including stakeholders, to understand the possible risks prevailing in the company. It further shows how the company is facing problems due to its borrowing, and it is becoming difficult for the entity to pay off its debts. However, for financial leverage, the total debt and total equity are calculated.
Here, the equity is the shareholder’s equity, including the retained earnings of the company. However, it is seen that the companies operating in the manufacturing sector have higher equity rate compared to the one operating in the ones in the service sector.
Here, total debt includes both current and long-term liabilities. The current liabilities can be considered to the one that the firm promises to pay with a year’s time or less if possible.
Common Leverage Ratios:
The ratios that are used to calculate financial leverage are as follow.
- Interest coverage ratio
- Debt to EBITDA ratio
- Debt to capital ratio
These three calculations are common in corporate finance. The commonly used calculation for financial leverage is the debt to equity ratio.
What are the risks involved in financial leverage?
Financial leverage means an improved level of earnings for the company it also results in some disproportionate loss of the company. These losses take place when the expense payments of asset become overwhelming as asset returns fall short of the estimated value. Therefore, the situation takes place when the asset level decreases to an unexpected level.
Scenario of the volatility of the stock price:
The company profit may be affected due to a rise in the level of financial leverage. This, in turn, would result in fluctuations in the stock price of the company. Therefore, it would be difficult to manage the stock price of the market properly. As a result of this, the firm has to pay a high rate of interest to its shareholders.
Effects of financial leverage
For calculating financial leverage ratio, it is related to variability in profit and it is contrary to the profit of the organization. The flexibility and dynamics of the company may impact on the leverage ratio. In this regard, it is seen that companies that have high leverage rate have low flexibility. The companies with high leverage level have less chances of success rate. They might have to take some tentative decisions in the long run of the business.
Financial leverage’s impact on company’s profit
Financial leverage refers to the part of a company’s operation that is financed with debt. Therefore, high financial leverage means that a huge part of the debt is in use. The following part of the article discusses the effect that financial leverage can show on the profit of the company.
How it has an impact on interest?
The financial leverage affects the profit of the company in the payment of interest. It might happen that you get a lower rate of interest for a loan. However, interest can make a good amount of investment. So, buyers purchase inventory and pay the related interest amount in order to carry the debt.
Growth and development of the company
To smoothly help a business to grow, you have to make out ways to have an easy flow of cash into the business. Either you have to opt for a loan, or you have to make use of investment money. However, in the long run, the business can generate profit, and it would help the business to grow.
Limitations of cash flow
Leverage prevents cash flow in the business. For this, it is important to set aside some amount for making payments such as interest payments and principal. This situation constricts the company from opting for any kind of additional investments or involving with new risks. This tendency may not impact the current profit earning condition of the company, but it can hinder the future growth of the company.
Therefore, the operating leverage becomes high when the fixed cost of the company becomes more than that of variable costs. In some cases, the provider of debt will restrict the level of risk that it will take and thus, it would indicate how much leverage it would allow.