Financial leverage is the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing.
In most cases, the provider of the debt will put a limit on how much risk it is ready to take and indicate a limit on the extent of the leverage it will allow. In the case of asset-backed lending, the financial provider uses the assets as collateral until the borrower repays the loan. In the case of a cash flow loan, the general creditworthiness of the company is used to back the loan.
How Financial Leverage Works?
When purchasing assets, three options are available to the company for financing: using equity, debt, and leases. Apart from equity, the rest of the options incur fixed costs that are lower than the income that the company expects to earn from the asset. In this case, we assume that the company uses debt to finance asset acquisition.
1. Powerful access to Capital
Financial leverage multiplies the power of every dollar you put to work. If used successfully, leveraged finance can accomplish much more than you could possibly achieve without the injection of leverage.
2. Ideal for Acquisitions, Buyouts
Because of the additional cost and risks of bulking up on debt, leveraged finance is best suited for brief periods where your business has a specific growth objective, such as conducting an acquisition, management buyout, share buyback or a one-time dividend.
Risks of Financial Leverage
1. Volatility of Stock Price
Increased amounts of financial leverage may result in large swings in company profits. As a result, the company’s stock price will rise and fall more frequently, and it will hinder the proper accounting of stock options owned by the company employees. Increased stock prices will mean that the company will pay higher interest to the shareholders.
In a business where there are low barriers to entry, revenues and profits are more likely to fluctuate than in a business with high barriers to entry. The fluctuations in revenues may easily push a company into bankruptcy since it will be unable to meet its rising debt obligations and pay its operating expenses. With looming unpaid debts, creditors may file a case at the bankruptcy court to have the business assets auctioned in order to retrieve their owed debts.
3. Reduced Access to More Debts
When lending out money to companies, financial providers assess the firm’s level of financial leverage. For companies with a high debt-to-equity ratio, lenders are less likely to advance additional funds since there is a higher risk of default. However, if the lenders agree to advance funds to a highly-leveraged firm, it will lend out at a higher interest rate that is sufficient to compensate for the higher risk of default.
5 Steps to use Leverage for your Financial Well-Being
Rule 1: Take a loan only when appreciation opportunity is real
Taking a loan for buying an appreciating asset such as an apartment makes sense, as long as you have evaluated the opportunity well and are confident about the long-term appreciation potential of the house. An easy way to understand this is:
Yield (capital appreciation + rental) >= rate of interest
Also take into account, the possibility of interest rates going up and future appreciation keeping up.
Rule 2: Don’t use leverage when downside risk is high
Leverage opportunities exist only when prospects seem uncertain (there is risk involved). When there is uncertainty, there is volatility, and hence the prospect of negative returns and loss of capital also exist.
This is exacerbated in opportunities that are highly liquid. In leveraged situations, such cases of negative returns can wipe out capital and lead to a huge liability on your head. E.g., borrowing to invest in the stock market is highly risky and should never be attempted.
A corollary to this rule is also that any short-term leverage opportunity that promises significant gains is also risky and downside risks in such cases should be carefully evaluated.
Rule 3: Leverage should be a choice, not a compulsion
-Taking a loan is nothing but borrowing from your future earnings to fund your present. So, unless the asset you are borrowing for is earning more than the cost of borrowing, you are leaving your future under-funded.
Hence, living within your means is important before you try using leverage. The ability to make a choice between liquidating existing assets versus using leverage to raise capital should always exist, and allows for rational assessment of investment opportunities.
-Similarly, using a credit card for purchases is fine, as long as you use it as a charge card, and pay it off fully on the due date. Revolving debt on a credit card because you cannot afford to pay it off is as good as a criminal offense that you are committing against your financial well-being.
Rule 4: Always have plans for your loan
In case the leverage decision passes the tests of Rules 1, 2 and 3, then this rule becomes important. Always be clear about the tenure of the appreciation opportunity, as well as your ability to repay your loan over this tenure, through clear visibility and assurance of future earnings.
Second, it could so happen that during this tenure, either drying up of cash flows to repay the loan or the depreciation of the underlying asset might mean an earlier-than-planned repayment of the loan. In such cases, your ability to repay the loan through other existing assets is an important aspect to help you decide whether you should use leverage.
Rule 5: Evaluate every loan as an option that fits in your overall plan
Last but not the least, every such leverage option that you evaluate should be subservient to your overall financial plan, and the priority of your financial goals within that plan. Taking leverage decisions without considering what it is doing to your overall financial situation, will harm your long-term financial well-being.
It is important to evaluate every leverage opportunity using the above rules, before you take a decision to take a loan. Remember, in your long-term wealth building journey, leverage, if used wisely, can be an accelerator, and if used unwisely, can put the brakes. Simply put, debt is bad, but leverage is better.
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.