Many people have heard of financial leverage or a financial leverage ratio but do not know its meaning. Or, if they do, then it is only a basic understanding of it. If you run an organization like a business, you must have deep knowledge of financial leverage because you might need it.
Knowing what financial leverage is will help ensure you manage your business correctly. It will make it easier for you to avoid having a higher debt-to-equity ratio. Being careful about the degree of financial leverage your business has can help you keep thriving and handle variable costs without too much volatility.
You should also know how to calculate financial leverage. This will make it easy to tell if your business is on track. Also, it will be easy to know if the assets purchased are generating good returns. In the end, you'll easily stay on track and grow your business.
This blog post explores all you need to know about financial leverage. It will look at what it entails and why you need it to increase your profitability. In addition, it will delve into the factors that affect financial leverage plus its various benefits and limitations.
Let's get started with it.
Financial Leverage Definition
This is the use of debt by a business to purchase more assets. The aim is to increase business productivity and generate more returns on equity. The profits generated from the assets purchased get used to clear the loans and expand business operations to bring more returns.
As a business owner, it's always vital to calculate financial leverage. It will help you know if the amount of debt you take will benefit your business or not. You can calculate it as a ratio of total debt to total asset value. We'll discuss deeper how to calculate financial leverage later in this post.
Once you calculate financial leverage, you know it is worth the effort. This means comparing the cost of borrowing money or debt and short-term or long-term returns from the purchased assets. A business takes various risks when going for financial leverage, so it is better if it gets the desired returns.
You can back the loan you take using two significant options. One is using the assets purchased as collateral until you repay the loan. Two is by using your business's creditworthiness to back the loan. Companies use the first option often — the second option usually won't favor a small business with no credit record, leaving you prone to high interest rates.
How Financial Leverage Works
That's your answer to the question, 'what is financial leverage?'. The next step should be to know how financial leverage works. Companies have at least two other options to consider before they even settle on the use of leverage to purchase assets or increase working capital, also known as operating income.
Here are the fundamental options to consider:
- Debt - Financial leverage falls under this category. You can borrow funds in the form of debentures, bonds, or commercial papers to purchase assets. These can then get repaid with interest.
- Leases - You can also acquire business assets through leasing. This method involves using a property for a specific period in exchange for a return on equity and an increase in net income.
- Equity - This entails giving ownership of your business to the shareholders. It involves selling your business's shares to get funds that you can use to purchase assets. It also means that your total equity decreases in most cases.
Despite having the other two options, many businesses prefer a higher degree of operating leverage. Debt financing isn't a bad option as long as you consider how much debt you amass. Thus, there's no problem in having debt as part of your company's capital structure if you can manage it well.
Example of Financial Leverage
The best way to understand how financial leverage works is through an example. Let's check out the example below.
Let's say you own company X and would like to buy 120 acres of land worth $1,500,000. But your balance sheet says you only have $500,000 in hand, and you decide to borrow $1,000,000. The borrowed amount is your financial leverage. This is plus interest, which let's say is $50,000 paid at the start of every year. However, you’re liable to see a percentage change in interest each year.
Another company, Z, wants to purchase 40 acres of land worth $500,000. And there's enough cash to buy it, so there's no need to borrow. This means company Z won't have financial leverage. However, both companies will have owned the two parcels of land.
We used pieces of land in our example because land is one of the best investments you can make. Also, land is not subject to depreciation unless under political instability, unfavorable climate, war, etc. Otherwise, you can resell it and repay your loan if it is not productive.
Another example of a good investment is gold. You can consider buying physical or paper gold to store value or make profits. Physical gold like bullion bars sold by Acre and gold coins can be worth considering for investment. Gold stocks, too, can help you multiply your business's profits.
Making the right choice when investing will help you get the expected returns. Thus, always seek financial advice when in doubt about a decision. You can consult on the best gold for investment or how to find reliable dealers like Acre to avoid making losses from borrowed funds.
Advantages of Financial Leverage
Your company can enjoy various benefits from using financial leverage. Knowing its potential benefits can make it easy for you to decide if it is worth considering. Here are its primary benefits:
- Economies of scale - Fixed costs can be significantly reduced when a business has financial leverage. It becomes easy to boost productivity and move from small-scale to large-scale production.
- Expansion of operations - Planning for your company's growth is one of the best steps you can take. Financial leverage makes it possible to do that effortlessly and enter new markets.
- Improves credit rating - The more a business borrows and pays on time, the better its credit record becomes. You can consider financial leverage as a way of increasing your business's creditworthiness.
- Lower tax burden - You can lower your business's tax burden by taking financial leverage. It will be easier to enjoy tax exemptions if you consider debts and liabilities.
- Higher shareholder profitability - A business's shareholders' equity increases as it grows and expands its operation. Financial leverage can help do this and increase profitability too.
- Increased cash flow - A business's cash flow represents its earning power or profit margin. It is easy to increase cash flow using financial leverage.
Those are the primary benefits of using financial leverage in the business. There's no doubt that a company can significantly grow if it uses financial leverage correctly. This means avoiding too much debt and honoring its financial obligations to improve its creditworthiness.
Limitations of Financial Leverage
Besides the various benefits financial leverage brings, it also has its limitations. It is also vital to know the disadvantages of financial leverage as a business owner. It will help you be sure of the decisions you make for your business. The limitations include:
- High risks - Business is all about taking risks to make profits. The risk in financial leverage is that you may not make profits from the assets purchased and could end up in debt.
- High rate of interest - loans come with an interest expense which can sometimes be too high. These interests could burden your business and make it challenging to thrive.
- Bankruptcy threat - As mentioned before, losses can put you into debts that, if accumulated, will be significant. Your business will be at risk of being declared bankrupt.
- Restrictions from Financial Institutions - Sometimes, lenders want to take control of a business with a loan. This could affect your ability to make critical business decisions.
These are the main limitations that come with financial leverage. Most of them are avoidable and depend on your decisions and your conduct in business. For example, it is easy to avoid getting into bankruptcy and hurting your credit record if you honor your obligations.
Also, you can choose a cash flow-backed loan to avoid getting restricted by the lender. Proper research will also ensure you do not get into an agreement with companies that charge high interests. In short, almost every adverse result that could come with leverage is avoidable.
You Should Start Considering Financial Leverage
Now you have a basic understanding of financial leverage. If you run a business, financial leverage is one of the tools you may consider for funding it. You can use debt financing to purchase assets like land, equipment, etc., and ensure you get a good return on investment.
All you need to do is control your company's financial leverage. If your company's debt is too high, repaying it can be a daunting task, and it could accumulate with time. Always be careful about choosing a lender by considering factors like interest payments and other loan terms.
It also will be a good idea to choose suitable investments. A good investment brings returns and doesn't lose value quickly. That's where gold comes in because it's not easy to run into losses with investment gold. You can speak to us about how you can start investing in gold bars today.
Sources:
Financial Leverage | readyratios
Advantages vs. Disadvantages of Leveraged Finance | The Hartford
Understanding Cash Flow vs. Asset-Based Business Lending: What's the Difference? | investopedia.