Leverage, also called financial leverage, includes any debt incurred by a company to buy more assets for further profit-making opportunities.
Instead of leverage, a company can acquire more equity capital. The downside is that using equity capital can reduce the earnings each share potentially makes for an investor, making leverage a more viable way to keep the value of shares at a consistent level.
As long as the financial leverage stays at a moderate level, the risk of failure remains relatively low.
In addition to allowing a company to invest more in their business, leverage has other advantages.
Financial leverage can increase the overall assets of the business, allowing it to pay off any debt or to invest further. Also, many tax jurisdictions view the interest expense from the debt created by leverage as tax deductible. This categorization of the interest expense from leverage reduces the net cost of the debt to the company or individual borrowing it.
On the other hand, leverage presents some disadvantages. The risk involved represents one of the most serious disadvantages, especially when business dealings go wrong, causing a company to take a loss. This loss translates to a reduction of the company’s equity capital and increases the debt-to-equity ratio of the business. Too much debt can lead to a potential bankruptcy, with investors left holding the bag.
Debt-to-equity ratio, one of the key factors of financial leverage, indicates the riskiness of a business’s financial structure. This ratio lets investors know how much debt the company carries in relation to its assets. Companies with a relatively low debt-to-equity ratio represent less of a risk financially, compared to a company with a higher ratio.
To figure a company’s debt-to-equity ratio, add together any long- and short-term debt, as well as the residual obligation amount of any leases, and divide the sum by the equity the company owns.
Financial contracts between a company and a lender, also called a covenant, usually stipulate limits on how much the company can borrow from the lender, often in the form of a maximum debt-to-equity ratio.
To get a better understanding of what a company owes in comparison to the company’s assets, lenders look at the company’s balance sheet. Companies create balance sheets at different time intervals, with the most common intervals set at once a month, every quarter, yearly or twice a year.
When going over a balance sheet, look for the total worth of the company’s assets, plus any liabilities and equity the company might own. The liabilities and equity should equal the assets, thus the name “balance sheet.” By comparing multiple balance sheets for the business over a span of time, investors can get an idea of the investment risk of a company.
Equity capital equals the current market value of everything a company owns minus any liabilities. A company does not repay equity capital to investors like it does debt capital.
Risk capital represents the part of a company’s equity capital out of which all losses are subtracted, including any business failings, errors in judgment or other circumstances that stand to cause a company to claim a loss on a venture or investment.
Companies with a high amount of equity capital make a more appealing investment for lenders.
Debt vs. no debt
When it comes to debt, the less a company has, the more likely they do not need to worry about failing and going into bankruptcy.
While many investors prefer a company with little to no debt, to some lenders, the risk of a higher debt is worth it if they get a higher overall return for the additional money they invest in a company.