Financial Leverage
Definition
Financial leverage refers to the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing. In other words, financial leverage is a strategy that companies use to increase their return on investment. The term "leverage" comes from the effect of using a lever in physics, where a small amount of force exerted on one end of a lever can move a much larger weight on the other end. In finance, a small amount of investment (equity) can control a large amount of productive assets and, therefore, yield a large profit or loss.
Types of Financial Leverage
There are two main types of financial leverage: operating leverage and financial leverage.
Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is.
Financial leverage, on the other hand, refers to the amount of debt that a company uses to finance its operations, in comparison to its equity. The higher the degree of financial leverage, the more volatile a company's earnings will be.
Calculation
The degree of financial leverage is calculated by dividing the total debt of a company by its total equity. This ratio is also known as the debt-to-equity ratio, and it provides an indication of a company's ability to cover its debt. A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt, which can result in volatile earnings.
Advantages and Disadvantages
Financial leverage can provide several advantages. It can allow a company to make large investments without having to raise a significant amount of capital. This can lead to higher returns on equity and on investment. However, financial leverage also comes with risks. If a company's return on investment is less than the cost of borrowing, then the company will lose money. Additionally, a high degree of financial leverage can lead to higher interest expenses and can increase the risk of bankruptcy.
Impact on Return on Equity
Financial leverage can have a significant impact on a company's return on equity (ROE). ROE is a measure of the profitability of a company, calculated by dividing net income by shareholders' equity. If a company can earn a higher return on investment than the cost of debt, then financial leverage will increase ROE. However, if the return on investment is less than the cost of debt, then financial leverage will decrease ROE.
Risk and Financial Leverage
Financial leverage increases the risk of a company. The higher the degree of financial leverage, the more debt a company has in relation to its equity. This means that the company has more fixed obligations to meet, specifically interest payments on its debt. If a company is unable to meet these obligations, it could face bankruptcy. Therefore, while financial leverage can increase the potential return on investment, it also increases the risk of loss.
Conclusion
In conclusion, financial leverage is a double-edged sword. It can increase a company's potential for high returns, but it also increases the risk of loss. Therefore, companies must carefully manage their degree of financial leverage to ensure that they can meet their debt obligations and maximize their return on investment.