FINANCIAL LEVERAGE: WHAT IS IT FOR, RATES AND EXAMPLE - DUDAS - 2025

The financial leverage is the degree to which a company uses the money you have borrowed, such as debt and preferred shares. It refers to the fact of incurring debt to acquire additional assets. The more financial debt a company uses, the greater its financial leverage.

As a company increases its debt and preferred shares due to financial leverage, the amounts to be paid for interest increase, which negatively affects earnings per share. As a result, the risk of capital return for shareholders increases.

The company must consider its optimal capital structure when making financing decisions; This way you can ensure that any increase in debt increases its value. With financial leverage, you invest more money than you have, being able to obtain more profits (or more losses) than if only the available capital is invested.

Companies with high leverage are considered at risk of bankruptcy if, for some reason, they cannot pay their debts, which could create difficulties in obtaining new loans in the future.

What is it for?

Financial leverage represents the extent to which a business is using borrowed money. It also evaluates the solvency of the company and its capital structure.

Analyzing the existing level of debt is an important factor that creditors take into account when a company wishes to apply for an additional loan.

Having a high level of leverage in a company's capital structure can be risky, but it also provides benefits. It is beneficial during periods when the company makes a profit, as it grows.

On the other hand, a highly leveraged company will struggle if it experiences a decline in profitability. You may have a higher risk of default than an unlevered or less leveraged company in the same situation. Essentially, leverage adds risk, but it also creates a reward if things go well.

When is it used?

A business acquires debt to purchase specific assets. This is known as "asset-backed loans," and it is very common in real estate and purchases of fixed assets such as property, plant, and equipment.

Equity investors decide to borrow money to leverage their investment portfolio.

A person leverages his savings when he buys a house and decides to borrow money to finance part of the price with a mortgage debt. If the property is resold at a higher value, a profit is made.

Business equity owners leverage their investment by having the business borrow some of the financing it needs.

The more that is borrowed, the less capital is needed, so any profit or loss is shared between a smaller base and, as a consequence, the profit or loss generated is proportionally greater.

Types of leverage

Operational leverage

It refers to the percentage of fixed costs with respect to variable costs. Using fixed costs, the company can magnify the effect of a change in sales on the change in operating profit.

Hence, the company's ability to use fixed operating costs to magnify the effects of changes in sales on its operating profit is called operating leverage.

It is an interesting fact that a change in sales volume leads to a proportional change in a company's operating profit due to the company's ability to use fixed operating costs.

A company that has high operating leverage will have a large proportion of fixed costs in its operations and is a capital intensive company.

A negative scenario for this type of company would be when its high fixed costs are not covered by profits due to a decrease in demand for the product. An example of a capital-intensive business is an automobile factory.

Financial appeceament

It refers to the amount of debt that a company is using to finance its business operations.

Using borrowed funds instead of equity funds can actually improve a company's return on equity and earnings per share, as long as the increase in earnings is greater than the interest paid on the loans.

However, overuse of financing can lead to default and bankruptcy.

Combined leverage

It refers to the combination of the use of operational leverage with financial leverage.

Both leverages refer to fixed costs. If they are combined, the total risk of a company will be obtained, which is associated with the total leverage or the combined leverage of the company.

The ability of the company to cover the sum of fixed operating and financial costs is called combined leverage.

Example

Suppose you want to buy shares in a company and have $ 10,000 to do so. The shares are priced at $ 1 per share, so you could buy 10,000 shares.

Then 10,000 shares are bought at $ 1. After a certain time, the shares of this company are priced at $ 1.5 per share; For this reason, it is decided to sell the 10,000 shares for the total amount of $ 15,000.

At the end of the operation, $ 5,000 was earned with an investment of $ 10,000; that is, a profitability of 50% was obtained.

Now we can analyze the following scenario to find out what would have happened if it had been decided to leverage financially:

Scenario with financial leverage

Suppose that, by borrowing from the bank, you obtained a credit for $ 90,000; therefore, 100,000 shares can be bought for $ 100,000. After a certain time, the shares of this company are at $ 1.5 per share, so it is decided to sell the 100,000 shares with a total value of $ 150,000.

With those $ 150,000, the requested loan of $ 90,000 is paid, plus $ 10,000 in interest. At the end of the operation we have: 150,000 - 90,000 - 10,000 = $ 50,000

If you don't take into account the initial amount you had of $ 10,000, you have a profit of $ 40,000. That is, a profitability of 400%.

On the other hand, if the shares had fallen to $ 0.5 instead of going up to $ 1.5, then they would have 100,000 shares worth $ 50,000, which would not even be able to face the $ 90,000 of the loan plus $ 10,000 of interest.

In the end he would end up with no money and a debt of $ 50,000; that is, a loss of $ 60,000. If we hadn't borrowed money and the stock had gone down, only $ 5,000 would have been lost.

References

1. Admin (2018). Financial appeceament. ExecutiveMoneyMBA. Taken from: executivemoneymba.com.
2. Investopedia (2018). Financial Leverage. Taken from: investopedia.com.
3. Harold Averkamp (2018). What is financial leverage? AccountingCoach. Taken from: accountingcoach.com.
4. Wikipedia, the free encyclopedia (2018). Leverage (finance). Taken from: en.wikipedia.org.
5. Ready Ratios (2018). Financial Leverage. Taken from: readyratios.com.
6. My Accounting Course (2018). Debt to Equity Ratio. Taken from: myaccountingcourse.com.
7. CFI (2018). Leverage Ratios. Taken from: corporatefinanceinstitute.com.