Financial Leverage: The Risks and Rewards of Using Debt to Finance Growth

Borrowing money from private lenders or banks allows individuals or enterprises to purchase assets or collect funding for project development. Such loan is referred to as financial leverage. Business owners have the opportunity to obtain finance or funds on short notice, which is typically beneficial for business expansion.

Let’s look deeper into this article to acquire more knowledge of financial leverage, its formulae, types, and ratios used in business.

What is Financial Leverage?

Companies use financial leverage as a strategy to increase their return on investment (ROI) by borrowing money to fund their operations. This means that rather than using their own equity to fund projects, companies have debt in the form of loans or bonds.

By doing so, they can increase the possible profits on their assets. However, it is vital to realize that financial leverage adds risk because the company must now repay borrowed cash with interest. If the business’s profits are insufficient to satisfy debt payments, it may face financial troubles.

How to Calculate Financial Leverage?

Financial leverage is measured using the debt-to-equity ratio. This ratio shows a company’s debt in relation to its equity. To determine the debt-to-equity ratio, divide the company’s total liabilities by its equity.

Here is the formula:

Debt-to-Equity Ratio = Total Liabilities / Total Equity

A larger debt-to-equity ratio shows greater financial leverage, which means the company is borrowing more money to fund its operations. However, a very high debt-to-equity ratio can be problematic because it increases the company’s exposure to financial troubles if it does not make enough revenues to fulfill its debt commitments.

Types of Leverage In Financial Management

Financial management uses two types of leverage: operating leverage and financial leverage.

• Operating leverage is the amount to which a company’s fixed costs affect its profitability. A corporation that has large operating leverage has a high share of fixed costs compared to variable expenses. This means that even tiny changes in sales volume can have a major impact on earnings. For example, a manufacturing company with high fixed costs for machinery and equipment will have a greater change in profit for a given change in sales volume than one with minimal fixed costs.
• Financial leverage is the use of debt to increase the return on equity. A corporation with high financial leverage has a high debt-to-equity ratio. This might raise both the company’s potential returns and the dangers associated with its investments. For example, a firm that borrows money to invest in a new project may get a larger return on equity if the initiative succeeds, but it also risks additional risk if it fails.

Both types of leverage can be advantageous or harmful to a firm, depending on factors such as industry, economic conditions, and the company’s unique circumstances. Understanding the consequences of operating and financial leverage is critical to good financial management.

How Financial Leverage Works?

Financial leverage works by increasing the possible return on equity. This is accomplished by borrowing money to fund investments instead of depending just on shares.

This is how it works.

• Borrowing Funds: A corporation obtains funds through loans, bonds, or other debt instruments. This loan boosts the company’s overall assets.
• Investment: Borrowed funds are used to purchase assets such as new equipment, expansion projects, or acquisitions.
• Return on Investment: If the investments are successful, the company will make money.
• Profits are calculated using the equity investment rather than the total assets due to the company’s use of borrowed funds. This can lead to a higher return on equity than if the company hadn’t used leverage.

For example, if a business invests $100 of its own equity and loans an additional $100 to fund a project, the total investment is $200. If the project makes $40 profit, the return on equity is 40% ($40 / $100). However, if the corporation had not employed leverage and invested only $100 of its own equity, the return on equity would have been 20% ($40/100).

It’s important to remember that financial leverage increases risk. If the investments fail, the company may be unable to generate enough income to pay off the debt, resulting in financial issues. As a result, it is critical for businesses to carefully weigh the benefits and dangers of adopting financial leverage.

Degree of Financial Leverage

The degree of financial leverage (DFL) indicates how sensitive a company’s earnings per share (EPS) are to fluctuations in operational income. It shows how much a company’s earnings per share (EPS) will vary for a given percentage change in operating income.

Formula

DFL = % Change in EPS / % Change in Operating Income

Interpretation

• DFL > 1 indicates that the company’s earnings per share are more susceptible to variations in operating income. This means that a little change in operating income can cause a significant change in EPS.
• DFL < 1 indicates that the company’s earnings per share (EPS) are less affected by operational income fluctuations. This means that a bigger change in operating income is required to create the same change in EPS.

Factors Affecting DFL

• Debt-to-equity ratio: Higher debt levels typically result in higher DFL, as interest payments on debt are fixed expenditures that can have a considerable influence on profitability.
• Tax rate: Higher tax rates can lessen the impact of fixed expenses on earnings, resulting in reduced DFL.
• Operating leverage: Companies with strong operating leverage (i.e., high fixed expenses relative to variable costs) have a greater DFL because fluctuations in sales volume can significantly affect operating profitability.

Importance of DFL

• Risk assessment: DFL assists investors and analysts in determining the risks connected with a company’s financial structure. A high DFL implies that the company’s earnings are more erratic, which may pose a danger to investors.
• Capital structure decisions: DFL can assist organizations in determining the best combination of debt and equity funding. A high DFL may indicate that the company is taking on too much debt, while a low DFL may indicate that it could benefit from borrowing more money to increase its profits.

Pros and Cons of Using Financial Leverage

Pros	Cons
Amplified Returns: Financial leverage can significantly increase a company’s potential returns on equity, especially during periods of growth and profitability.	Increased Risk: Using debt to finance operations can increase the company’s risk of financial distress, particularly if the business experiences economic downturns or operational difficulties.
Tax Benefits: Interest payments on debt are often tax-deductible, which can reduce a company’s overall tax burden.	Financial Flexibility: Excessive debt can limit a company’s financial flexibility, making it more difficult to obtain additional financing or respond to unexpected challenges.
Cost-Effective: Debt financing can be more cost-effective than equity financing, especially when interest rates are low.	Agency Costs: Using debt can lead to agency costs, as lenders may impose restrictions on the company’s operations or require additional fees.
Market Signaling: In some cases, using debt can signal to investors that the company’s management is confident in its future prospects.	Debt Covenants: Debt agreements often include covenants that restrict a company’s activities or require it to maintain certain financial ratios, which can limit its flexibility.

Difference Between Operating Leverage and Financial Leverage

Feature	Operating Leverage	Financial Leverage
Definition	The extent to which a company’s fixed costs influence its profitability.	The use of debt to amplify the returns on equity.
Factors	Fixed costs, variable costs, sales volume.	Debt-to-equity ratio, interest rates, tax rates.
Impact	Affects the sensitivity of profits to changes in sales volume.	It affects the sensitivity of earnings per share (EPS) to changes in operating income.
Formula	Degree of Operating Leverage (DOL) = % Change in Operating Income / % Change in Sales Volume	Degree of Financial Leverage (DFL) = % Change in EPS / % Change in Operating Income
Implications	Higher DOL means greater sensitivity of profits to sales fluctuations.	Higher DFL means greater sensitivity of EPS to changes in operating income.

What is a Good Financial Leverage?

A “good” financial leverage ratio is defined by numerous factors, including industry, firm size, and economic conditions. In general, an acceptable amount of financial leverage is regarded as optimal since it can increase returns without exposing the organization to excessive risk. However, the appropriate ratio might vary greatly between industries and companies.

For example, industries with large fixed expenses, such as manufacturing or utilities, may be able to withstand higher levels of financial stress due to their consistent income streams. Companies in cyclical industries, such as construction or retail, may be more vulnerable to economic downturns and therefore benefit from lower leverage.

Finally, the appropriate financial leverage ratio for a company depends on its unique circumstances and risk tolerance. Companies must carefully assess the possible benefits and dangers of using leverage, as well as maintain a balanced approach that is consistent with their long-term financial objectives.

Which Factor Increases Financial Leverage?

Increased debt levels are the primary driver of financial leverage. When a corporation faces greater debt compared to its equity, it becomes more highly leveraged. This means that a greater share of the company’s assets are funded with borrowed cash, which can increase both the potential rewards and the dangers connected with the company’s investments.