What Is Financial Leverage?
In business, financial leverage is the use of borrowed capital—usually in the form of corporate bonds or loans—to finance operations in order to generate income.
In order to grow in value, companies need to hire, expand, conduct research, develop new products and services, purchase equipment, and lease warehouses and offices. If a company does not have enough cash on hand to finance these activities, it must either issue additional equity (stock) or borrow money.
Companies “leverage” borrowed capital by using it to generate income and increase the value of the business. The more money a company borrows, the more “leveraged” it becomes. Ideally, the income generated from the use of borrowed capital should exceed the cost of borrowing it (i.e., interest payments). The more a company’s debt-generated income exceeds its cost of borrowing, the more effectively it is using leverage.
Why Do Businesses Use Leverage?
When a company issues common stock to raise money, it gives up a portion of its ownership to shareholders. When a company issues corporate bonds or takes out a loan, on the other hand, it is able to invest in new projects without relinquishing any ownership. When a company’s debt-financed investment pays off by increasing income, the company’s 222return on equity (ROE) increases because it didn’t issue additional equity in order to boost income.
How Do Businesses Use Leverage?
When companies sell corporate bonds or take out loans, they do so to fund specific income-generating projects. As mentioned above, common uses of debt financing include hiring, the purchase of assets like plants or equipment, research and development efforts, and even marketing. Additionally, debt financing may be used to acquire other businesses whose assets can be incorporated into the company’s income-generating strategy.
Financial Leverage Example
An east coast-based beverage company whose beverages were sold in stores and restaurants across the country might use leverage in the form of a corporate loan to finance the purchase of a new beverage production and canning plant on the west coast in order to reduce the cost of transportation its inventory across the country\.
By using a loan instead of issuing new shares, the company would not relinquish any additional ownership to stockholders. Ideally, the money saved on transportation would outweigh the cost of borrowing money to purchase the new plant in the long term, resulting in increased income for the company and a higher return on equity.
How Is Financial Leverage Measured?
Most investors and analysts evaluate leverage using leverage ratios, which express the degree to which a company’s operations or assets are financed by debt. Several leverage ratios exist, but the most popular is the debt-to-equity ratio.
Popular Leverage Ratios Used by Investors
- Debt-to-Equity (D/E) Ratio: The debt-to-equity ratio (calculated by dividing a company’s total debt by its shareholders’ equity) is a great way to compare how much of what a company owns and does is financed with borrowed money vs. hope much is financed via investor dollars.
- Debt-to-Total Assets Ratio: The debt-to-total assets ratio (calculated by dividing a company’s total debt by the value of all of its assets) allows investors to understand what percentage of a company’s assets (e.g., plants, property, equipment, and intangible assets like goodwill and intellectual property) were financed with borrowed money.
- Debt-to-Capital Ratio: The debt-to-capital ratio (calculated by dividing a company’s total debt by its total capital) offers insight into a company’s capital structure by framing a company’s debt as a proportion of its total capital (i.e., debt plus equity).
How Much Leverage Is Healthy for a Company?
In general, a debt-to-equity ratio of around 1 and a debt-to-total assets ratio of around 0.5 might be considered “normal.” That being said, how much leverage is considered healthy varies quite a bit between industries, and some sectors (e.g., banking) use leverage far more than others. For this reason, comparing the leverage ratios of an automotive company to those of an internet company wouldn’t be very meaningful.
Within an industry, however, if a company is much more leveraged than its peers, it is likely a riskier investment, as its potential for default is higher. A company that is substantially less leveraged than its peers, on the other hand, could be considered a safer investment within its industry.
When evaluating leverage, company age is also an important factor. It is normal for startups and younger companies in growth phases regularly finance many of their assets and operations with debt, so high leverage ratios shouldn’t necessarily scare investors off when it comes to newer, smaller-cap growth companies.
