Leverage means using one thing to achieve another in a layman's language. For instance, data has been an important tool for all kinds of business today. Businesses leverage data to understand their customers, design products, and make informed decisions.
This blog post will detail financial leverage to help you understand whether you business has it.
Understanding Financial Leverage
You can also call financial leverage "trading on equity." Most businesses, especially startups, practice some degree of financial leverage. However, many owners may not know what you do.
So, what's financial leverage? It is the practice of borrowing money to purchase assets for your business. This is with the hope that the gains the asset will bring will exceed the cost of acquiring it. In short, it's investing borrowed money with plans of multiplying it and getting profits.
Financial leverage aims at increasing the potential return on investment of a business. However, that means taking various risks that we'll discuss later in this article. This makes lenders limit how much debt they can extend to a business after assessing the borrower's records.
The financial provider uses the assets acquired using the money as collateral. However, this will depend on whether it is an asset-backed or cash-flow-backed loan. Companies need to avoid situations where they could be "highly leveraged" when taking advantage of financial leverage.
Being highly leveraged means that a firm's debt structure is majorly made of debt and not equity as it should be. This isn't a good position because it can affect a firm's ability to repay loans. This is unless the asset invested in brings the expected returns to the business.
How Financial Leverage Works (With Example)
This section will look at that in detail as a good background understanding will help you know if it is worth it. We'll use an example to make it easier for you to understand.
Let's say you own company X that deals with swimming pool installation. You would like to expand the firm's operations by acquiring an asset that will help increase profits. There are two main options - to acquire the asset using equity or consider debt financing.
If you do not have enough finances, debt could be the most preferred option. That's where financial leverage comes in. You find a lender to finance the asset you need and then use your profits from the asset to repay the loan. Such a loan can make it easy to acquire the asset you need.
Here're the steps that the financial leverage process follows:
- Obtain the debt capital you need to get started
- Leverage the obtained finances by purchasing the assets your business needs
- Use the assets to generate profits and start repaying the loan.
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How Do You Interpret Financial Leverage?
Measuring financial leverage can be a daunting task for a starter. You can use leverage ratios and financial data from your company's balance sheet or any other statement to do this effortlessly. Here are the ratios or formulas that should help you measure your company's debt.
- Debt-to-assets ratio = Total debt/Total assets
- Debt-to-equity ratio = Total debt/Total equity
- Debt-to-capital ratio = Total debt/(Total debt + Total equity)
- Debt-to-EBITDA ratio = Total debt/Earnings Before Interest Taxes Depreciation & Amortization
- Asset-to-equity ratio = Total Assets/Total Equity
These formulas will help you control your business's debt-to-equity ratio. In the end, it will be easy for you to access loans in the future. That will make it easy for your business to build and have a good credit record. As a business that wants to grow, this should be top on your plans.
Main Advantage of Financial Leverage
Financial leverage comes with various benefits for businesses. As a business owner, it's the potential benefits of financial leverage that will help you decide whether to practice it or not. It will be easier for you to visualize the returns and keep track of your progress over time.
The primary benefit of financial leverage is that it empowers businesses. Financial leverage can help a business increase its earnings per share and return on equity. In the end, this can help boost the amount of revenue a firm makes and help business owners reach their goals.
Risks of Financial Leverage
- Bankruptcy
- Volatile stock prices
- Reduced access to debts
Despite its benefits, financial leverage also comes with a set of risks. Keeping the risks of financial leverage in mind can make it easy to avoid them. Also, it will help you find alternative ways to repay the interests that come with the debt used to purchase assets.
Here are the major risks of financial leverage:
Bankruptcy
This is one risk that every business owner should keep in mind. Financial leverage can push a business to bankruptcy if not well-managed. This is especially for businesses that have low barriers to entry. It means that the profits and revenues of such a business will fluctuate.
That will then affect the business's ability to repay its debts in good time. What this means is that the business could end up in court. Creditors might file lawsuits seeking intervention from the courts to recover their money. This could lead to auctioning of assets to recover loans.
Volatile Stock Prices
Leverage needs to be controlled to benefit a business. Too much of it can lead to a firm's stock prices volatility. This is because a highly leveraged business will have large swings in profits. This will mean that company shareholders will not be sure of what to expect as annual returns.
Also, it won't be easy to track the stocks owned by employees of the firm. The major downside is that the firm may incur more expenses. The interests to be paid to shareholders will increase, and this could, in the end, affect the company's ability to get the expected revenues and profits.
Reduced Access to Debt
High financial leverage can lock your business out of loans. As said earlier, lenders review a firm's ability to repay a loan before approving an application. Thus, potential lenders will look at your business's debt-to-equity ratio before deciding if you're worth lending to or not.
You'll get locked out if your business has a high debt-to-equity ratio for obvious reasons. That is a sign that you may not repay the amount of debt or do so in time. Should a lender agree to approve your application, they'll charge higher interest to cover your business's high risk of default.
Those are the major risks of financial leverage. These risks should help you prepare yourself for different situations. For instance, you need to know how high financial leverage will affect your access to future loans. That will help ensure you borrow responsibly and within certain limits.
Conclusion
There's no doubt that financial leverage is helpful to a business that wants to grow and increase its capacity to generate revenues and profits from the market.
But there are various risks that come with high financial leverage. This blog post has touched on a few advantages of the benefits of financial leverage so you can better weigh the risks. You can use the insights shared above to benefit from financial leverage.
In addition, you need to ensure that you invest the funds wisely. You can consider assets that will bring returns and won't decline in value in case of economic turmoil. Gold, as said before, is a perfect example. You can talk to Acre Gold about getting started as a bullion bars investor.
Sources:
Leverage Definition: What Is Financial Leverage? | investopedia
Understanding Cash Flow vs. Asset-Based Business Lending: What's the Difference? | investopedia.
Highly Leveraged Company | financial-dictionary.thefreedictionary