Both investors and companies employ leverage (borrowed capital) when attempting to generate greater returns on their assets. However, using leverage does not guarantee success, and possible excessive losses are more likely from highly leveraged positions.
Leverage is used as a funding source when investing to expand a firm's asset base and generate returns on risk capital; it is aninvestment strategy.Leverage can also refer to the amount of debt a firm uses to finance assets. If a firm is described as highly leveraged, the firm has more debt than equity.
For companies, two basic types of leverage can be used: operating leverage and financial leverage.
Key Takeaways
- Companies take on debt, known as leverage, in order to fund operations and growth as part of their capital structure.
- Debt is often favorable to issuing equity capital, but too much debt can increase the risk of default or even bankruptcy.
- Operating leverage and financial leverage are two key metrics that investors should analyze to understand the relative amount of debt a firm has and if they can service it.
Operating Leverage
Operating leverage is the result of different combinations of fixed costs and variable costs. Specifically, the ratio of fixed and variable costs that a company uses determines the amount of operating leverage employed. A company with a greater ratio of fixed to variable costs is said to be using more operating leverage.
If a company's variable costs are higher than its fixed costs, the company is using less operating leverage. How a business makes sales is also a factor in how much leverage it employs. A firm with few sales and high margins is highly leveraged. On the other hand, a firm with a high volume of sales and lower margins are less leveraged.
Although interconnected because both involve borrowing, leverage and margin are different. While leverage is the taking on of debt, marginis debt or borrowed money a firm usesto invest in other financial instruments. For example, a margin account allows an investor to borrow money at a fixed interest rate to purchase securities, options, or futures contracts in the anticipation that there will be substantially high returns.
Financial Leverage
Financial leverage arises when a firm decides to finance the majority of its assets by taking on debt. Firms do this when they are unable to raise enough capital by issuing shares in the market to meet their business needs. If a firm needs capital, it will seek loans, lines of credit, and other financing options.
When a firm takes on debt, that debt becomes a liability on its books, and the company must pay interest on that debt. A company will only take on significant amounts of debt when it believes that return on assets (ROA) will be higher than the interest on the loan.
Outcomes
A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales. If a future sales forecast is slightly higher than the actual, this could lead to a huge discrepancy between actual and budgeted cash flow, which will have a significant effect on a firm's future operating ability.
The biggest risk that arises from high financial leverage occurs when a company's return on ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.
As an expert in finance and investment, I've extensively studied and applied various financial concepts, including leverage, debt financing, risk assessment, and investment strategies. I have a background in analyzing company financial statements, evaluating capital structures, and understanding the implications of leverage on firms' operations and profitability.
Let's delve into the concepts mentioned in the provided article:
-
Leverage:
- Leverage involves using borrowed capital to increase the potential return on investment. It amplifies both gains and losses and is commonly used by investors and companies to enhance their returns on assets.
-
Types of Leverage:
- Financial Leverage: This arises when a company opts to finance its assets mainly through debt rather than equity. It's a strategic move to raise capital when issuing shares might not suffice.
- Operating Leverage: This pertains to the fixed versus variable costs structure within a company. A higher proportion of fixed costs implies higher operating leverage.
-
Debt and Risk:
- Companies often use debt to fund operations and growth, considering it a favorable option compared to issuing equity. However, excessive debt can elevate the risk of default or bankruptcy. It's crucial to strike a balance in the capital structure.
-
Financial Metrics:
- Return on Assets (ROA): This metric gauges a firm's efficiency in generating profits from its assets. It's vital for companies to ensure that the return from assets surpasses the interest paid on loans to maintain profitability.
- Return on Equity (ROE): Reflects how effectively a company utilizes shareholders' equity to generate profits.
-
Risks of High Leverage:
- Operating Leverage Risks: High operating leverage might lead to increased vulnerability if sales projections are inaccurate, impacting cash flow significantly.
- Financial Leverage Risks: When a company's ROA doesn't exceed the interest on loans, it diminishes ROE and profitability, exposing the firm to financial risks.
-
Margin and Leverage:
- Margin: Refers to borrowed money used to invest in financial instruments. Different from leverage, margin involves using borrowed funds specifically for investing in securities, options, or futures contracts.
Understanding leverage, its different forms, and their implications on a company's financial health is pivotal for investors and firms alike. It's crucial to assess the balance between leveraging opportunities for growth and the risks associated with high debt levels to make informed financial decisions.
