Financial leverage addresses a company’s level of financial risk exposure. Based on how a company finances its operations, leverage is a tool that creates the opportunity to be more profitable in the long term. However, this is met with increased exposure to risk and higher short-term expenses. To capitalize on this opportunity, a company leverages its short-term position by utilizing debt.
In general, there are two methods of business financing: debt and equity. If a company needs to buy more inventory, it could pay for the goods by taking out a loan or using the owner’s money. The issuance of stock is an example of equity in which the owner has an underlying ownership stake in the company. Alternatively, the utilization of debt increases the company’s underlying risk, but it preserves the previous equity positioning. This is the essence of financial leverage: increasing the risk within the company to yield potentially higher net income for the existing owners.
Return on Equity
To demonstrate financial leverage, a great financial metric to use is return on equity. If a company has net income of $100,000 and equity of $10,000, its current return on equity is $100,000 / $10,000, or 10. Assume that the company needs $10,000 of new capital. It could issue stock or personally invest the capital as equity. Using the same figures above, its return on equity is $100,000 / $20,000, or 5. This means less revenue is earned for every dollar of equity. Alternatively, the company could borrow money. By incurring debt, equity remains unchanged, and its return on equity remains 10. However, the company is now in a riskier financial position because it has a legal obligation to pay back the loan. It must now use cash flow from operations to pay back the loan. However, whatever profits that are earned are extended to fewer owners, meaning higher income for each owner.
Risks and Benefits of Leverage
The main risk of leverage becomes apparent as a company takes on too much debt. The amount of leverage a company incurs should be directly related to its liquidity and solvency. If a company takes on too much debt, it will be unable to meet its payment requirements with its short-term and long-term cash flows. In addition, as a company takes on more debt, the cost of borrowing more money increases through higher interest rates. The stock price or equity valuation of a company will be reduced based on the overall risk of the company as it incurs more debt. However, when it is used properly and within safe constraints, financial leverage can be beneficial to a company. Utilizing low interest rates, a company can raise money inexpensively. From a long-term perspective, the owners will benefit from having less equity as the result of adding other owners. The company must weather the added costs of debt to experience the benefits of financial leverage.