Why Is Financial Leverage Important?
Almost every business operation requires money and making prudent financial management a vital aspect of running an enterprise.3 min read
Why is financial leverage important for the survival of a business? Almost every business operation requires money, but companies have finite resources, making prudent financial management a vital aspect of running an enterprise.
Financial leverage is the ratio of equity and financial debt of a company. It is an important element of a firm's financial policy. Financial leverage can also mean the use of company financial resources at a fixed charge. Financial leverage of two implies that for one dollar of equity, there are two dollars of financial debt. This allows the company to use debt to finance assets acquisitions.
The concept of leverage is common in the business world. It is mostly used to boost the returns on equity capital of a company, especially when the business is unable to increase its operating efficiency and returns on total investment. Because earning on borrowing is higher than interest payable on debt, the company's total earnings will increase, ultimately boosting the earnings of stockholders.
Leverage can be favorable or unfavorable. It is positive when earnings are greater than debt costs. However, it is negative if the company's earnings are lower than the cost of securing the funds. Debt financing is an essential source of capital to support the limited investment of stockholders. Additionally, it helps to achieve the ideal level of return on equity.
Importance of Leverage
Leverage provides the following benefits for businesses:
- Leverage is an essential tool a company's management can use to make the best financing and investment decisions.
- It provides a variety of financing sources by which the firm can achieve its target earnings.
- Leverage is also an important technique in investing as it helps companies set a threshold for the expansion of business operations. For example, it can be used to recommend restrictions on business expansion once projected return on additional investment is lower than cost of debt.
How to Measure the Impact of Leverage
The impact of leverage is measured by subtracting the economic profitability ratio from the return on equity ratio after deducting corporate tax. Because stockholders' return on equity of capital is usually higher than economic return ratio, leverage plays an important role in helping to achieve investors' expectations regarding return on equity. For this reason, financial leverage is measured based on how additional debt affects the earnings per share of common stockholders.
Understanding Financial Leverage
Your home mortgage provides the simplest way to understand the principle of financial leverage. Most of the time, the effect of leverage on the homeowner is usually favorable. However, financial leverage needs to meet two important requirements to become beneficial. First, the borrower must have the capacity to make payments to avoid repossession. Second, the leverage depends on the value of the underlying asset. If the asset gains value, leverage magnifies the potential profit on the property, but if the asset loses value, leverage reduces the returns on investment. Leverage becomes unfavorable if these two conditions are not present.
The late 1980s saw the abuse of leverage when the management of several companies, goaded on by investors and low interest rates, took far more debts than they could repay to finance expansion and acquisitions. Many of these companies, including Orion Pictures, Live Entertainment, Carolco, New World Pictures, and Cannon Group ended up filing for bankruptcy when they could not repay their toxic loans. Most of these companies, many of which are from Hollywood, forgot that they still had to repay their debts even if the projects they financed with the funds failed. To use leverage successfully, a company must use realistic projections, sound management decisions, common sense, and an unbiased appraisal of the risks.
The problem with leverage is that most people are sentimentally optimistic about its ability to boost earnings without thinking of the potential debts they must repay if the plan fails. When new businesses launch, they either hit the ground running as the new sensation in town only to lose their steam when a new company diverts buyers' attention away from them; or start slowly and build a reputation as more people get to know of their excellent service delivery. Nevertheless, borrowing increases the fixed cost of the business. If you want borrowed funds to be effective, it is important to identify potential pitfalls.
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