If a company has too much debt in relation to its operating cash flows and equity, it is considered to be overleveraged. An overleveraged corporation has trouble covering its interest and principal payments, and is often unable to cover its operating expenses due to high costs incurred as a result of its debt load, leading to a downward financial spiral.
As a result, the company must borrow more money to remain afloat, and the crisis worsens. When a corporation restructures its obligations or files for bankruptcy protection, the spiral normally comes to an end.
What is Leverage?
Leverage is the use of various financial tools and or borrowed capital to increase the amount of potential return. A company or an individual is said to be overleveraged if the debts are greater than equity, where equity is defined as the value of assets minus the liabilities on said assets.
Companies use leverage to finance their operations and to try and increase their net profits. By using debt financing, a company has a far greater sum to invest in business operations than it would have had previously.
When does it Occur
When handled properly, debt can be beneficial, and many businesses use it to expand their operations, buy essential goods, improve their facilities, and for a variety of other purposes. In certain cases, taking on debt is preferable to other methods of raising money, such as issuing stock. Taking on debt does not imply relinquishing ownership of the business, and external participants have no control about how the debt is used. Debt may also assist a corporation in being profitable if it is managed properly. Only when a corporation is no longer able to handle its debt does it become a serious issue.
When a company borrows so much money, it becomes unable to pay interest, principal repayments, or keep up with payments for its operating expenses due to the debt burden. Companies who borrow too much and are overleveraged are at risk of going bankrupt if their company suffers a setback or the market falls.
Taking on too much debt puts a company’s finances under a lot of stress because the cash outflows needed to service the debt consume a large portion of the company’s revenue. Since they do not have the same expensive debt-related strain on their cash flow, a less leveraged business could be better placed to withstand revenue declines.
Financial leverage can be measured in terms of either the debt-to-equity ratio or the debt-to-total assets ratio.
Disadvantages of Overleveraged
Leveraged finance has its perks but it comes with a higher-than-normal amount of debt which could increase your exposure to financial risk. It is also more costly as high yield bonds and leveraged loans pay higher interest rates as compensation for taking in greater risks.
When an organisation becomes overleveraged, it suffers a slew of negative consequences. Some of the negative consequences are mentioned below.
- Loss of Assets
If a corporation becomes so overleveraged that it declares bankruptcy, its contractual responsibilities to the banks from which it borrowed money kick in. Banks typically have seniority over a company’s assets in this situation. In other words, if a corporation is unable to repay its debt, banks may seize the company’s assets and liquidate them for cash to pay off the unpaid debt. A company’s assets, if not all, can be lost in this way.
- Leveraging and India Inc
Corporate debt has grown at a very fast pace in the past decade in our country, and it is only 1.6 times lesser than the debts of the Union government today. This outstanding debt is now equal to more than a third of India’s GDP (34 percent in 2013-14). According to the CEO of India Ratings, Atul Joshi,“most of the Indian companies have rating downgrades in the recent past due to overleveraging.” This is why overleveraging is a top concern for Indian firms.
An example of this principle is “house flipping”. “A house flipper” will buy a house, renovate it (using borrowed money or not) and then sell it for a greater price. Dave Ramsey points out, “If you want to win with money, you need to take “payment plans” out of your vocabulary. Successful people don’t finance their couches. Or their dining room tables. Or even their cars. If you have to put it on a payment plan, you can’t afford it. As the old saying goes, “Broke people ask, ‘How much per month?’ and rich people ask, ‘How much?’” The main factor for getting rich is to understand how you can use someone else’s money for yourself, whether it’s by borrowing or by utilising investment capital. Hence, leveraging is key to a richer you.
- Inability to Gain New Investors
It would be almost impossible for an overleveraged business to recruit new investors. If they receive a large equity stake with a recovery framework, investors who provide liquidity in return for an equity stake will find an overleveraged business to be a bad investment. Giving up significant equity stakes is not optimal for a business because it lacks leverage over decision-making.
- Constrained Growth
Companies take out loans for particular purposes, such as expanding product ranges or purchasing equipment to boost revenue. When it comes to loans, there is always a deadline for making interest and principal payments. If a business borrows with the hope of increased profits but is unable to expand until the debt matures, they could be in a difficult situation. Paying back the loan without improved cash flow can be disastrous, limiting the company’s ability to finance operations and expand.
- Is financial leverage good or bad?
Leverage is not either inherently good or bad. It expands the positive or negative effects of income generation and productivity of the assets in which we invest. In order to determine the effects of financial leverage, one should be aware of its potential impact and volatility.
- Leverage Safely
It is preferred to use leverage within one’s risk parameters, in line with one’s financial goals. As is highlighted in the principle of ways and means, leveraging is the way to boost your means, which in turn can be used to generate a greater profit. Every company uses leverage as part of its financial strategy. Very often, people tend to think only about the left side of their balance sheet and forget right side. Thinking more like a corporate magnate and employing leverage in strategic ways can help individual investors swell their profits. Along with investments and wealth planning, credit and leveraging is just another bullet in the barrel for the savvy investor.
- Restriction on Future Borrowing
Before lending capital, banks perform extensive credit checks and assess a company’s ability to repay its debt in a timely manner. If a corporation is already heavily leveraged, the chances of a bank lending money are slim. Banks are averse to taking on the risk of losing money. And if they do take that chance, the interest rate paid would almost certainly be exorbitant, making borrowing less than desirable for a business already in financial distress.