Financial Leverage

What is “Leverage”?

Leverage, which is also known as financial leverage or gearing, refers to companies using debt (i.e. borrowed money or debt financing) to finance the purchase of assets, expand an asset base, invest in business operations, or increase return on investment. Investors can also use leverage in their investment strategy – borrowing money to invest, can magnify investment returns.

It must be mentioned at the outset, that while the use of leverage can amplify profits, it can also magnify losses (i.e. the loss is much greater if the investment goes bad).

Leverage

Financial leverage (part of the financing activities of a firm) refers to the proportion of debt in the overall company’s capital structure. It refers to the way a company finances its assets through some combination of equity and debt. The more debt financing a company employs in its capital structure, rather than equity, the more financial leverage it is employing. A firm can enhance its financial leverage by issuing fixed income securities (for example, bonds) or by borrowing directly from a bank.

A ratio, known as the ‘debt-to-equity ratio’, is used to determine the amount of financial leverage of a company. This ratio simply shows the proportion of a company’s debt relative to its equity (debt-to-equity ratio = total debt/total equity *100) and is used to assess the level of perceived risk in the capital structure of the company.

For example, if a company’s total borrowings (debt) is US$100m and its total equity is US$20m, then the debt-equity ratio will be 500%. Alternatively, one can calculate debt as a percentage of capital (debt + equity) i.e. debt/capital. If a company has a very high debt-equity ratio, then it might be a risky company to invest in. Two factors can help determine the acceptable level of leverage – the industry or sector to which the company belongs too and the market sentiment.

Another key leverage ratio is the ‘interest cover ratio’. This ratio informs us of the level of a firm’s income relative to its interest (payment) commitments. The formula is:

Formula

Interest cover = earnings before interest and tax (EBIT) / interest payable
or operating cash flow / interest charges

The interest cover ratio tells us how easy or difficult it will likely be for a company to service its debt. The higher (lower) this ratio, the lower (higher) the probability of a company defaulting on its interest payments and going into liquidation.

Since companies require cash to service their debts, it is better to use operating cash flows, rather than EBIT in the computation of the interest cover ratio.

Leverage is used by companies to enhance their return on equity (net income/shareholder’s equity) and increase their earnings. However, the use of leverage involves risk. If a company is within an industry or sector with steady revenues, large cash reserves, along with high barriers to entry, it can risk-taking on high levels of debt or excess leverage. However, excessive leverage (i.e. too much debt) is a risky proposition, particularly if a company is in a more cyclical sector or industry. This is because the sales and profits of such companies tend to fluctuate substantially from year to year – this can increase the risk of default on interest payments or bankruptcy over time.

An excessive use of leverage or borrowing too much adds to a company’s fixed costs (i.e. the additional interest payment each year) and leads to too many interest payment obligations. If there is a marked decline in the company’s business for several years – resulting in losses for a couple of years, then it might default on its debt-related payment obligations and not survive. Its net assets could get wiped out.

Essentially, the key point to note is that excessive leverage implies high risk and high reward.

Effect of Leverage on Returns – Example

Let’s assume that ‘Company A’ proposes to undertake a major new investment of US$10m. It can exercise the option of going through the route of 100% equity financing i.e. it can opt for going to its shareholders and offer them additional shares via a rights issue to raise this amount.

The proposed investment is expected to give a return of 20% per annum i.e. US$2m per year on US$10m raised from the company’s shareholders.

The shareholders of the firm would be able to get a significantly higher rate of return if the company decided to use leverage i.e. an alternative capital structure. They could obtain US$8m from bondholders and US$2m from shareholders.

The workout below shows how using leverage magnifies the returns for a company (i.e. how it benefits shareholders). The assumption is that bondholders require a 5% rate of return per annum or year. It is evident that use of leverage can amplify returns for shareholders in this example from 20% to 80% per year.

A word of caution: while the use of leverage may seem enticing from the point of view of shareholders of a company, it is a high risk proposition. Should a company take on too much debt (i.e. excess leverage) and if earnings before interest and tax (EBIT) fall due to an economic slowdown or a recession (which is expected to be protracted), then shareholder’s earnings could fall rapidly. This will have downside implications for the company’s share price and dividends.

Further, as stated above, if there are several years of losses, the company may not be able to survive the downturn in its businesses, due to the high level of interest payment commitments (as a result of taking on too much debt). There is a risk of bankruptcy if a company cannot service its debt commitments.