Financial leverage refers to the use of debt to amplify returns from an investment. Companies can employ financial leverage by taking on loans and issuing bonds to raise capital that is then invested to expand operations and generate additional profits. Leverage allows firms to increase assets, invest in growth, and boost overall returns beyond what could be done through equity financing alone.
However, leverage also introduces risks by increasing fixed costs in the form of interest expenses. Excessive debt levels make a company more vulnerable to insolvency if cash flows decline. Finding the optimal capital structure and properly managing risk is crucial when utilizing financial leverage.
What is Financial Leverage?
Financial leverage is the use of borrowed funds to amplify returns from an investment. Companies can raise capital through debt financing by issuing bonds, taking loans, or other debt instruments. This debt capital can be invested to expand operations and generate additional profits.
If the returns from the investment funded by debt exceed the cost of the debt financing, then overall net returns are higher. This enhances net income available to shareholders compared to if the company had only used equity capital.
- A company invests $100,000 in expanding its factory
- The $100,000 investment is funded 50% from equity ($50,000) and 50% from debt ($50,000)
- The investment generates a return of 12% or $12,000 in additional profits
- The interest cost on the debt used is 6% ($3,000)
- Without leverage, returns would be 12% on $50,000 equity = $6,000
- With leverage, returns are $12,000 – $3,000 interest = $9,000
The use of financial leverage amplifies overall returns from $6,000 to $9,000.
The primary risk is that fixed interest costs can magnify declines in profitability during downturns. Companies with too much debt may struggle to service loans if cash flows drop.
Operating vs Financial Leverage
There are two main types of leverage – operating leverage and financial leverage:
This relates to the company’s cost structure. Higher amounts of fixed operating costs vs variable costs create operating leverage. Companies with higher operating leverage see earnings rise/fall faster as revenues increase/decrease.
This refers to the use of debt financing. More debt in the capital structure leads to higher financial leverage. It amplifies returns and EPS but also introduces insolvency risks if debt serviceability declines.
The two can interact to magnify risk and returns further. Companies should optimize operating and financial leverage based on their business model and industry.
READ ALSO: What is a Leverage Ratio?
Formula for Financial Leverage
The financial leverage formula measures the sensitivity of a company’s earnings per share (EPS) to changes in operating profit.
It compares earnings before interest and taxes (EBIT) to earnings before taxes (EBT) to quantify the degree of financial leverage:
Financial Leverage = EBIT / EBT
A higher ratio indicates greater financial leverage, meaning a company’s EPS is more sensitive to changes in EBIT.
Let’s walk through an example:
Company A has:
- EBIT = $20 million
- Interest expense = $5 million
- EBT = $15 million
Financial leverage = EBIT / EBT = $20 million / $15 million = 1.33x
The leverage ratio of 1.33x tells us that Company A’s EPS changes by 1.33% for every 1% change in EBIT. Higher financial leverage makes EPS more volatile.
Examples of Financial Leverage
There are several ways companies can employ financial leverage:
- Loans – Bank loans are a common way to access debt financing for leverage. Revolving credit facilities provide flexible borrowing.
- Bonds – Issuing corporate bonds raises longer term capital from debt investors. Allows borrowing large amounts at (usually) fixed rates.
- Mortgages – Real estate assets can be used to obtain secured mortgage debt to fund property investments and expansions.
- Leases – Finance leases allow the use of leased assets while spreading payments over time like debt. Operating leases also provide some leverage benefits.
- Preferred shares – Preferred stock is considered a hybrid debt/equity instrument. It provides leverage benefits by offering fixed dividends without diluting common equity.
Companies combine various debt instruments at targeted ratios to create an optimal capital structure that maximizes returns while balancing risk tolerance.
Financial Leverage Ratio
The financial leverage ratio measures the sensitivity of a company’s earnings per share (EPS) to changes in operating profit quantified as EBIT. The formula is:
Financial leverage ratio = EBIT / EBT
EBIT = Earnings before interest and taxes EBT = Earnings before taxes
A higher financial leverage ratio indicates greater use of debt relative to equity, and higher sensitivity of EPS to changes in operating profit.
Analysts monitor the financial leverage trend over time and compare to industry averages to assess risk. Sudden increases could signal rising vulnerability to downturns.
Effects of Financial Leverage
Utilizing financial leverage impacts three key financial metrics:
- Return on equity
- Return on assets
- Earnings per share
Let’s examine how leverage affects each area.
Return on Equity
Return on equity (ROE) measures net income generated relative to shareholder equity. ROE will increase with the use of financial leverage if the returns on assets funded by debt exceed the interest cost.
- For example, if debt with a 5% interest rate is used to buy assets earning 10%, ROE is amplified.
- However, the same leverage magnifies declines in ROE if asset returns decrease below interest rates.
Overall, prudent leverage that keeps asset returns above funding costs will boost ROE. But excessive debt or unfavorable market shifts can result in leverage decreasing ROE.
Return on Assets
Similarly, return on assets (ROA) can be enhanced through financial leverage if debt is used judiciously to invest in assets that generate returns higher than their cost of debt.
- As the proportion of lower-cost debt funding increases relative to equity, the overall return earned on assets rises.
- However, ROA shrinks if leverage is too high or invested capital is allocated poorly.
Proper use of debt leverages up ROA while maintaining reasonable interest coverage margins and asset returns.
Earnings Per Share
Earnings per share (EPS) measures net income attributable to common shareholders per share.
Financial leverage directly influences EPS in two key ways:
- Interest expense on debt decreases net income and EPS
- Debt provides “free” capital that allows issuing fewer shares, keeping EPS higher
Up to a point, the latter effect outweighs the former, increasing EPS. However excessive leverage feeds growing interest costs that eventually reduce EPS.
Finding the optimal debt level that maximizes EPS growth involves balancing these dynamics. Conservative leverage discipline boosts EPS generation for shareholders.
Advantages of Financial Leverage
Used strategically and in moderation, financial leverage provides important benefits:
- Returns amplification – Debt multiplies returns by funding additional income-producing assets. This enhances overall shareholder returns.
- Lower cost of capital – Debt interest rates are generally lower than the cost of equity financing. Replacing equity with cheaper debt reduces overall capital costs.
- Tax benefits – Interest expenses are tax deductible which provides significant savings. The tax shield effect is greater for higher tax rate firms.
- Maintain control – Debt does not dilute ownership or relinquish control like issuing equity would. Leverage allows controlling current owners.
- Funding flexibility – Varied debt instruments allow flexible financing. Revolving credit facilities provide on-demand borrowing capacity.
Used prudently, financial leverage is a powerful tool for boosting returns and maximizing EPS for shareholders.
Disadvantages of Financial Leverage
However, financial leverage also carries important risks and downsides, including:
- Insolvency risk – Excessive debt makes it harder to service loans if earnings and cash flow decline, leading to potential default and bankruptcy.
- Inflexibility – Debt covenants and obligations reduce financial flexibility to pursue other opportunities. Debt must be serviced regardless.
- Profit volatility – The fixed nature of interest costs tends to amplify and accelerate declines in profitability and EPS.
- Financing costs – Heavy debt burdens can increase borrowing costs and restrict access to additional financing.
- Conflicts of interest – Debt introduces potential conflicts between shareholder interests to maximize equity and creditor interests in stable income.
- Economic exposure – Rising interest rates, and higher refinancing costs hurt highly leveraged companies more in economic downturns.
While leverage enhances returns during stable growth periods, it can dangerously impair firms when conditions deteriorate. Prudent leverage discipline is key.
Good vs Bad Financial Leverage
Financial leverage is considered “good” when it enhances returns and boosts EPS without increasing risk.
Some characteristics of good leverage:
- Conservative debt levels with adequate safety margins
- Stable revenues and healthy cash flows to service debt
- Returns on assets exceed the cost of debt capital
- Interest expenses are easily covered by operating income
- Lowers weighted average cost of capital (WACC)
- Flexibility to pay down debt quickly if needed
“Bad” financial leverage tends to involve:
- Excessive debt relative to equity and ability to service obligations
- Tight interest coverage ratios and limited liquidity
- Debt used to fund low-return investments or losses
- Inflexible obligations that constrain company finances
- Spiraling interest costs that swallow cash flow
- Increased weighted average cost of capital
- Overall higher business risk and chance of financial distress
The optimal amount of “good” leverage varies widely by industry and company. Management should tailor capital structure accordingly.
Financial Leverage by Industry
Ideal financial leverage levels differ substantially between industries based on revenue stability, ability to service debts, growth rates, and need for investments.
Technology – Rapid growth and risky innovations limit debt capacity. Equity financing is typical. Debt ratios usually below 30% are normal.
Consumer Staples – Steady demand and robust cash flows support more debt. Debt ratios of 30-50% are common.
Industrials – Moderate leverage around 30-50% balances growth needs and cyclical revenues. Transportation may sustain higher leverage.
Healthcare – Providers can utilize 40% or higher debt ratios with stable recurring revenues. Biotechs use little debt due to R&D costs.
Utilities – Capital-intensive assets produce steady income allowing more debt. Ratios above 50% are typical.
Management should benchmark leverage against comparable sector firms and set capital structure policies accordingly.
Tips for Managing Financial Leverage
Here are some key tips for prudently managing financial leverage:
- Set clear capital structure policies on target debt levels and risk tolerance
- Maintain adequate debt service coverage ratios (DSCRs) above 1.5x
- Use debt primarily to fund investments with returns exceeding cost of capital
- Keep financing costs and terms flexible for refinancing ability
- Match debt terms to life of assets funded – use longer-term debt for longer-lived assets
- Monitor asset returns frequently to avoid prolonged negative leverage
- Prepare contingency plans for reducing leverage if conditions deteriorate
- Maintain open communication with creditors and rating agencies
- Compare leverage metrics to competitors and industry benchmarks
- Evaluate the impact on weighted average cost of capital and optimal capital structure
When used strategically, financial leverage allows companies to amplify returns beyond what could be achieved through equity alone. But imprudent amounts of debt increases risk of financial distress. Companies should weigh the merits and risks of leverage and aim for capital structures optimized to their specific situation. With sound policies and governance, financial leverage can enhance shareholder returns while maintaining financial stability through business cycles.
Frequently Asked Questions
What is considered a good financial leverage ratio?
A good financial leverage ratio depends on the industry and business model. As a broad guideline, ratios below 1.5x are generally prudent for most companies. Higher leverage may be acceptable in stable sectors like utilities.
How does financial leverage impact stock prices?
Borrowing more at lower fixed rates boosts EPS and ROE during good times, which tends to support higher stock valuations. But excessive leverage also increases risk, which can depress stock prices. Moderate leverage that improves returns without undue risk can enhance stock prices.
Is it better to have high or low operating leverage?
High operating leverage is better for companies with steady, predictable revenues that can cover fixed costs. High operating leverage is riskier for businesses with seasonal or cyclical demand. The optimal amount depends on revenue stability.
How does financial leverage impact tax payments?
Interest costs are tax deductible, so higher financial leverage reduces taxes paid and provides more tax savings. This tax shield effect provides another benefit of leverage. But excessive interest costs can also create losses that provide no tax benefit.
Do companies with high growth need more financial leverage?
Typically no, high-growth companies often avoid substantial leverage due to unpredictable cash flows. Rapidly growing firms most often use equity financing to fuel expansion and take on debt only conservatively. Exceptions are capital-intensive growth companies.
Can excessive financial leverage cause bankruptcy?
Yes, unsustainable debt levels that are not properly managed can increase the risk of default and eventual bankruptcy. If earnings decline, high interest costs and rigid loan terms can create a downward spiral leading to insolvency.
In another related, What is an Expense Ratio and What’s a Good One?