At its simplest, leverage is a tactic geared at multiplying gains and losses. Leveraging existing assets to get exponentially more return can be a risk-intensive process and represents a significant aspect of financial strategy and capital structure. Achieving leverage can enable significant competitive advantages despite the risk and can also accelerate the speed of revenue acquisition exponentially.
The standard way to accomplish leverage is through borrowing, via debt and equity, to invest at a much higher scale than one’s current assets would allow. In order to borrow substantial amounts of capital, firms must pursue a variety of financial sourcing and be able to back up their debts with valuable assets, or collateral. Even with a great deal of collateral, borrowing big means risking big. Interest rates ensure that the strategic discussions around expanding leverage take into account the risk and return trade-offs.
The standard definition of financial leverage is a tactic to multiply gains and losses, calculated by a debt-to-equity ratio with the following formula:
The debt-to-equity ratio also plays a role in the working average cost of capital (WACC), as the overall interest on financing represents the break-even point that must be obtained to achieve profitability in a given venture. WACC is essentially the overall average interest an organization owes on the capital it has borrowed for leverage.
If the organization owes 10% on all equity and 5% on all debt, what is the weighted average cost of capital?
That means that the weighted average cost of capital is 8%. For every $10,000 borrowed, this organization will owe $800 in interest. Profit must be higher than 8% on the project to offset the cost of interest and justify this leverage.
Leverage is exponentially riskier the more it is utilized. A useful way to view leverage is the overall existing assets of an organization compared to the amount of money they owe.
EXAMPLESuppose you own a company with an overall net worth of $1 million. If you were to be leveraged at a total of 1.5 times (i.e., financed at $1.5 million), this would put you at some risk – arguably, a reasonable amount.
EXAMPLEBefore Lehman Brothers went bankrupt, they were leveraged at over 30 times; $691 billion in financial leverage compared to $22 billion in assets. A mistake of this scale, on both the lenders and the Lehman Brothers, threatened to topple the global economy itself.
Taking on debt, as an individual or a company, will always bring about a heightened level of risk due to the fact that income must be used to pay back the debt even if earnings or cash flows go down. From a company’s perspective, the use of financial leverage can positively – or sometimes negatively – impact its return on equity as a consequence of the increased level of risk.
However, if a company is financially over-leveraged, a decrease in return on equity could occur. Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments. If the risk of the investment outweighs the expected return, the value of a company’s equity could decrease as stockholders believe it to be too risky.
There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage. While involuntary leverage is certainly not a good thing, it is typically caused by eroding equity value as opposed to the addition of more debt. Therefore, it is typically a symptom of the problem, not the cause.
When evaluating the riskiness of leverage it is also important to factor in the value of the company itself and its activities. If a company borrows money to modernize, add to its product line, or expand internationally, the additional diversification will likely offset the additional risk from leverage. The upshot is, if value is expected to be added from the use of financial leverage, the added risk should not have a negative effect on a company or its investments.
Operating and financial leverage can be combined into an overall measure called “total leverage.” Total leverage can be used to measure the total risk of a company and can be defined as the percentage change in stockholder earnings for a given change in sales. In other words, total leverage measures the sensitivity of earnings to changes in the level of a company’s sales.
Total leverage can be determined by a couple of different methods. If the percentage change in earnings and the percentage change in sales are both known, a company can simply divide the percentage change in earnings by the percentage change in sales. Earnings can be measured in terms of EBIT, earnings before interest and taxes, or EPS, earnings per share. While EBIT can be determined by referencing a company’s income statement, we can determine earnings per share by dividing the company’s net income by its average price of common shares.
Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Thinking About Financial Leverage” TUTORIAL.