Financial leverage is the outcome of borrowing money to support investments that increase a company’s asset base and produce returns on risk capital. Leverage, or the use of different financial instruments or borrowed capital, is an investing strategy that uses borrowed money especially to boost the possible return of an investment.
Financial Leverage: An Overview
In order to carry out a project or investment, leverage is the utilisation of debt (loan funds). A project’s potential returns are multiplied as a consequence. In the event that the investment doesn’t work out, leverage will also increase the possible negative risk. When anything is described as “highly leveraged,” it suggests there is more debt than equity in the business, asset, or investment in question.
Financial Leverage=Operating Income/Net Income
A corporation is considered to be overleveraged if its operating expenditures exceed its profits and it is unable to make payments on its loans’ interest rates. If sales slump or profitability decline, an overleveraged corporation faces the possibility of bankruptcy. Unsustainably high levels of leverage make a corporation less able to absorb declines in revenue.
In order to raise the amount of the prospective return, leverage is the employment of several financial instruments, including borrowed capital. When debts exceed equity which is calculated as the value of assets less the liabilities on those assets—a business or individual is said to be overleveraged. Leveraged financing is a strategy used by businesses to fund operations and boost net profits.
The Importance of Financial Leverage
Leverage is crucial since it gives investors possibilities. This chance entails risk, thus it is frequently suggested that new investors have a thorough grasp of leverage and its possible drawbacks before taking on leveraged positions. Financial leverage may be systematically utilised to structure a portfolio such that it can profit from successful investments and suffer even more when bad ones come along.
Personal Financing through Leverage
Your earnings or losses can be multiplied via the use of leverage. If expenses outweigh income from an asset or if the value of the asset declines, a loss may result.
Leverage can come from many different places, including:
- In order to finance a portion of their acquisition with mortgage debt, many people use their savings as leverage when buying homes.
- People frequently take out loans from investment brokers to make market investments.
- By borrowing the money they require to run their firms, company owners leverage their financial situation.
Disadvantages of Over Leveraged
Although leveraged finance provides advantages, it also carries a greater-than-average burden of debt, increasing your exposure to financial risk. Additionally, it is more expensive since high yield bonds and leveraged loans have higher interest rates because they take on bigger risks.
India Inc. and Leveraging
In our country, corporate debt has increased rapidly over the last ten years and is currently just 1.6 times less than the obligations owed by the Union government. More over a third of India’s GDP is now equivalent to this outstanding debt (34 percent in 2013-14). Atul Joshi, CEO of India Ratings, claims that overleveraging has recently resulted in rating downgrades for the majority of Indian corporations.
How Is Financial Leverage Calculated?
There are several methods for calculating financial leverage. Leverage ratios are a group of financial statistics that examine a company’s amount of debt in relation to its various assets. The two most used measures of financial leverage are debt-to-equity (total debt divided by total equity) and debt-to-assets (total debt divided by total assets).
There is an entire suite of leverage financial ratios used to calculate how much debt a company is leveraging in an attempt to maximize profits. Several common leverage ratios are listed below.
Debt-to-Assets Ratio = Total Debt / Total Assets
By looking at what proportion of its assets was bought with loan, a corporation may determine its leverage. To calculate the equity-to-assets ratio, a business can subtract the debt-to-assets ratio by one. A corporation has used leverage to fund its assets if the debt-to-assets ratio is high.
Debt-to-Equity Ratio = Total Debt / Total Equity
Leverage may be calculated by a firm just by looking at how assets have been funded, rather than what the company really owns. The debt-to-equity ratio is used to evaluate the amount of debt that a firm has taken on to the amount of equity that it has raised from shareholders or private investors.
A corporation has more debt than equity if its debt-to-equity ratio exceeds one. A corporation may not necessarily be overly leveraged if this is the case. Every business and industry operates differently, which may call for a larger or lower percentage.
What Is a Good Financial Leverage Ratio?
Every investor and business will have a particular taste for what constitutes a healthy financial leverage ratio. Some investors seek to keep their debt levels as low as possible because they are risk averse. Other investors view leverage as a chance and a way to obtain funds that can increase their earnings.
Leverage in Finance: Beneficial or Harmful?
It’s not always good or terrible to use leverage. It increases the impacts of income production and asset productivity, whether they are favourable or unfavourable, on the assets we invest in. One should be knowledgeable of the possible impact and unpredictability of financial leverage before determining its implications.