Have you ever thought about what financial leverage is? You have probably heard about it many times, but somehow, you are still unsure of its full definition?
Financial leverage is the term that is used to describe a particular investment strategy using borrowed funds, specifically using numerous financial instruments or capital that is borrowed for increasing the desired return of investment.
But, how does it work? What are the potential risks of failure, and what is the formula of the financial leverage? Find out in the text below.
The deeper explanation of financial leverage
Those who are still unaware of how financial leverage functions need to be aware that leverage exists to increase the return on equity. Nevertheless, an excessive amount of it significantly increases the risk of failure. It’s because it becomes so difficult to repay that debt.
When it comes to the financial leverage formula, you need to be aware that it is measured as the ratio of the total assets to total debt. In other words, as the proportion of debts to assets increases, the amount of financial leverage increases as well.
The uses to which that debt can generate returns than the interest expense associated with the debt is why financial leverage is favourable. Numerous firms prefer using financial leverage rather than getting more equity capital which can quickly reduce earnings per share of shareholders.
What are the potential risks of using financial leverage?
Here is what you need to know when it comes to the potential risks of using financial leverage. Although it can result in enhanced earnings for a firm, it may also result in losses which can be a big disaster.
These losses may occur primarily when interest expense payments for one asset overwhelms the one who is the borrower. It happens because the asset returns are insufficient.
It often happens when interest rates increase to very unrealistic levels or when the asset declines in value. Also, please be aware of the potential bankruptcy, volatility of stock price, and reduced access to more debts.
How to operate with financial leverage in the right way?
So, if you are wondering how to operate with financial leverage, keep in mind that the term refers to the fixed costs to variable costs that a firm incurs in a certain period. For example, in case the ratio of fixed costs exceeds the number of varying costs, a firm is known to have a pretty high operating leverage.
That firm is considered sensitive to sales volume changes and volatility, which may affect their returns of the capital they’ve invested and the firm’s EBIT.
The advantages and disadvantages of financial leverage
The advantages of financial leverage are:
- Favourable tax treatment – the interest expense, in numerous tax jurisdictions, is tax-deductible. That reduces its net costs to the one who is a borrower.
- Enchanted earnings – the entity can earn a disproportionate amount of its assets thanks to financial leverage.
The disadvantage of it is that, unfortunately, financial leverage can also lead to disproportionate losses.