Usually, companies have the choice to choose between either equity finance or debt finance to fund their operations. While equity finance may not usually involve any conditions, debt finance may come with certain restrictions. It is because debt finance providers will limit the risk they want to take on it. Similarly, some debt finance may come with security requirements.
A concept that usually relates to the use of debt is financial leverage. It is a crucial metric for a company and its stakeholders.
What is Financial Leverage?
For companies, financial leverage refers to using borrowed capital to fund projects and expecting the returns on them to exceed the cost of borrowing. In simpler words, when companies use debt finance to support their projects or investments, it results in financial leverage. Companies introduce financial leverage to maximize shareholders’ wealth.
How to measure Financial Leverage?
There are various metrics that companies and investors may use to calculate financial leverage. Among those, the most crucial one is the debt-to-equity ratio.
The debt-to-equity ratio helps determine the amount of financial leverage of a company or entity. It calculates the portion of a company’s debt finance relative to its equity finance. It can assist users in understanding the level of debt associated with companies’ capital structure. Similarly, it can also give other information, such as the probability of defaults against debt obligations.
The formula to calculate the debt-to-equity ratio of a company is straightforward. All the information required to calculate it is available in the company’s balance sheet. The debt-to-equity ratio formula is as follows.
Debt-to-Equity Ratio = Total Debt / Total Equity
The total debt of a company refers to the sum of its current and non-current liabilities. Similarly, total equity consists of a company’s shareholders’ equity.
The debt-to-equity ratio is not a definitive statistic for companies. While it can show how much debt a company has accumulated, the ratio may differ for each industry. Therefore, when considering a company’s D/E ratio, it is crucial to look at it comparatively.
There are also other ratios that relate to leverage. These may include the Debt to Capital ratio or Debt to EBITDA ratio. Another metric that doesn’t measure financial leverage but is closely associated with it is the Interest Coverage Ratio.
What are the risks associated with Financial Leverage?
Financial leverage, if used efficiently, can maximize a company’s profitability. Similarly, it can increase shareholders’ wealth. However, financial leverage may also come with risks. When using debt finance to make investments into projects, companies must incur borrowing costs. There is a risk that these costs exceed the returns received from the project. Therefore, it can create losses for the company.
Companies that have higher financial leverage always face the risk of defaults. Especially in industries with a limited number of customers or lower profitability, having higher debt finance can be risky. It can result in the risk of bankruptcy and put the company into liquidation.
Similarly, financiers, such as investors and financial institutions, prefer companies with lower financial leverage. Therefore, companies that have higher financial leverage may limit their financing options. Similarly, as their financial leverage raises, the costs of obtaining new finance also increase.
Financial leverage is the use of debt finance to fund a company’s investments or projects. The best measure of a company’s financial leverage comes from the debt-to-equity ratio. For companies, higher financial leverage can come with some risks, as mentioned above.