When purchasing investment assets, a company or individual investor has three options for capital raising: using equity, debt, and leasing. So, what is special about financial leverage that many investors prefer it?
1. What is financial leverage?
Financial leverage is the use of borrowed money (debt) to fund the purchase of assets with the expectation that the income or capital gains from the new asset will exceed the cost of borrowing.
This allows the borrower to gain potential profits from investment activities with only a small portion of their own money. The borrowed money could come from banks or financial institutions.
In most cases, banks or financial institutions will set limits on the level of risk they are willing to accept and the degree of leverage they will provide.
Asset-backed lending: the financial provider uses the asset as collateral until the borrower repays the loan. Cash flow loans: the creditworthiness of the company is used to support the loan. Unlike asset-backed lending, cash-flow loans do not require collateral. Instead, the loan is granted based on past cash flows and forecasts. The downside is adding debt to the company’s balance sheet. And, if cash flows decline, the company will have difficulty repaying the loan and the interest. Investing in securities: Investors can use leverage to buy stocks through margin loans, options, and futures contracts. Although leverage can increase the profits of an investment, there is a downside: if the investment is inefficient, it can increase the potential risk and losses of the investment.
2. How to calculate leverage in investment
There isn’t just one formula for calculating financial leverage — investors and financial analysts use various ratios to measure leverage. It all depends on the factor being analyzed.
Here are some of the most common ways to calculate leverage ratios:
Debt-to-equity ratio: This number helps measure the company’s reliance on debt, calculated by dividing total debt by equity. The higher the ratio, the greater the leverage used by the company.
Equity ratio: The equity ratio is the ratio between total assets and total equity, particularly important for an investor when considering whether to invest in that company. The equity ratio tells you how the company’s equity has been used, whether business growth depends on equity or on debts. The larger the equity, the more leverage the company has.
Degree of financial leverage: This ratio measures how the company’s earnings per share (EPS) increases or decreases for each unit change in earnings before interest and taxes (EBIT).
Debt-to-EBITDA leverage ratio: This ratio compares the total debt of the company with earnings before interest, taxes, depreciation, and amortization (EBITDA).
3. The significance of using financial leverage
Financial leverage is not only used for personal investment purposes but is also a tool chosen by many businesses for the following reasons for example to compensate for the lack of capital so that businesses can maintain operations and seize strong growth opportunities. Loans and interest are counted as financial expenses of the business, which are then deducted from taxable income. Therefore, if the organization knows how to use the leverage method, it will quickly increase profits.
4. Advantages of financial leverage
Financial leverage can allow businesses and individuals to optimize borrowed capital for investments. This is a strategy to expand profits and promote growth. For example, a real estate investor could buy multiple properties and increase profits by using some loans, rather than investing all in cash. For businesses, leverage can support investments beyond their capabilities, such as investing in new offices or investing in new machinery, equipment, and technology. Additionally, financial leverage can help a cash-strapped business in daily operations or sales spikes without the necessary products to fulfil orders.
5. Financial leverage risks
Similarly, financial leverage can increase profits for investments but can also multiply losses if the investment fails. This can be a particularly risky form of finance. When using leverage to invest in stocks, if stock prices drop, the investor’s net asset value will also decrease. The decrease will correspond to the leverage ratio the investor uses. For example, if the investor uses a leverage ratio of 1:2, they will lose twice as much as usual.
Investing always comes with risks, not only that, but with leverage, companies also have to consider repaying the borrowed money. At this point, the company or investor may need additional money to cover losses or risk being underwater and in debt. For loans tied to collateral, you could be foreclosed on the collateral if you can’t pay.
Financial leverage can be especially risky in companies with low barriers to entry or cyclical sales cycles. In both cases, profits can vary greatly from year to year, or even within the same year, making it difficult to consistently repay loans and increasing the default rate.
Reducing access to more debt. When lending money to companies, financial providers assess the financial leverage of the company. For companies with a high debt-to-equity ratio, lenders are less likely to advance additional funds due to the higher risk of default. However, if lenders agree to advance money to a high-leverage company, they will lend at a higher interest rate enough to compensate for the higher default risk.
6. Effective use of financial leverage
Because leverage is a multifaceted financial tool, it is inherently complex and can cause both gains and losses for a business or an individual investor. Understanding its benefits and limitations can help you consider expanding business investment and determine whether your company is ready to use this financial tool.
There must be a good direction, carefully calculated before deciding to use this tool. Choose reputable financial institutions when borrowing money, such as banks and well-known credit organizations. Because these units always have stable, clear interest rates to prevent bankruptcy risk. Be cautious in evaluating the assets that you plan to use leverage to purchase. Because the value of that asset will rise/fall over time. Therefore, build a financial strategy slightly lower than the target aimed at. Only register for a loan that fits within a stable repayment range. Focus on cash flow to generate high profits. Always consider the risks before making any important financial decisions.
In conclusion, financial leverage has a lot of profit potential, but it can also make the investor pay much more than the amount borrowed. Financial leverage, at least when it comes to investment, should be for experienced investors who can handle high risks. I hope this article has helped everyone understand what financial leverage is. Follow and share more articles from Vietcap if you find them useful.