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Leverage in Financial Management – Explained Simply

Financial leverage is one of the most discussed and essential concepts in finance. It refers to the management of borrowed capital with the aim of increasing the potential of returns on investment. Debt also provides the capacity to increase the impact of gains realised from investment. It is significant in individual and corporate decisions on how and where to invest. By learning about leverage in financial management, it is possible to understand certain factors affecting investment and financial management for maximum returns.

Various Types of Leverage in Financial Management

Financial leverage, however, comes in many forms, and each has its uses. These types can be discussed further to distinguish their concepts and see what advantages they can offer for commerce.

Financial Leverage

The most recognised is financial leverage. It is the process by which an organisation acquires capital to finance business activities. The aim is to get a rate of return higher than the cost of funds sought through borrowing. This type of leverage is usually witnessed in instances where the firm launches bonds or takes loans so as to fund new ventures or widen its operational capacity.

Operating Leverage

In one way or another, operating leverage is connected to the firm’s cost structure. Operating leverage refers to the proportion between fixed costs and total costs; therefore, a company with more operating leverage will have more fixed costs. This shows that every sales increase leads to a proportional increase in operating income. Manufacturing firms, for instance, will be seen to have a high operating leverage due to their immense fixed costs.

Example: In a manufacturing firm, a large investment in machinery is a fixed cost, and therefore, a high increase in production (and sales) will automatically bring high returns because the cost does not change with output.

Combined Leverage

Combined leverage, or total leverage, sums up operating and financial leverage. It provides the total exposure and expected gain/loss from a company by taking into account both sources of leverage. It quantifies the total risk and possible gain that a company is exposed to by using the two types of leverage. This approach assists organisations in comprehending the sum of money they devote to risk and the potential reward that they may obtain.

Example: Combined leverage is where a company with high fixed costs relies on debt to finance its operation. High sales can be achieved this way, but low sales using this method result in a high risk.

Also read: Functions of financial management

Detailed Explanation of How Financial Leverage Works

To see how leverage in financial management works, let’s now illustrate the use of financial leverage with the following steps. For instance, a company may wish to order new machinery worth $1 million with the aim of increasing production rates. The company has two options: financing it from cash generated by the business (equity) or by going out to get a loan (debt).

Option 1: Using Equity Only

If the company finances the acquisition of $1 million with only Equity, then there is no debt on the machinery. Sales revenue above the cost of a higher production level is a real gain. If production increases revenue by $200,000, the return on investment is straightforward: It means achieving $200,000 profit on $1 million of investment, which is 20%.

Option 2: Using Leverage

If, for instance, the company decides to borrow $500,000 and contribute $500,000, then the leverage now would be calculated as follows: suppose the interest rate in borrowing this $ 500,000 might be 5 % per year; therefore, the business incurs $ 25,000 in interest per year.

However, if the machinery still increases revenue by $200,000, then the formulas are different. The company earns a total of $175,000 after paying interest of $25,000. With only $500,000 of its own funds invested, the equity return is $175,000 on $500,000 or 35%.

Analysing the example above, one can see that leverage in financial management has more beneficial effects. By borrowing funds, the company raised its return on equity figure from 20% to 35% by the end of the next year. But there’s a catch. If the machinery failed to rev up production as expected, the company would still be paying $25,000 in interest, which would have negative impacts on the profitability of the company, hence leading to complications.

Also read: Objective of financial management

Distinguishing Between Financial Leverage and Margin Trading

Comprehensive Guide to Calculating Common Financial Leverage Ratios

Advantages of Using Financial Leverage in Business

There are, however, several key advantages that leverage in financial management brings to the table, which is why it is well-suited if used correctly.

Enhancing Shareholder Returns

Another important aspect of financial leverage is its ability to increase shareholder profits. Corporations may increase their value and provide higher returns to shareholders by financing their operations with borrowed money at a lower cost than the value produced by investment.

Improving Capital Efficiency

Leverage helps firms strengthen their capital structure. Businesses may improve their capital utilisation by striking a balance between debt and equity, therefore financing projects and growth without lowering ownership.

Providing a Tax Shield

Interest payments on debt are typically tax-deductible. This tax shield reduces the overall tax burden, increasing the company’s after-tax income and making debt financing more attractive than equity in some cases.

Facilitating Growth and Expansion

Leverage also facilitates achieving a balance between development possibilities and risks, as some growth potential cannot be funded only through equity financing. This provides finance for acquisitions, new initiatives, and market outreach, all of which are critical to a company’s success.

Unlocking Economies of Scale

Using debt to invest in larger facilities or advanced technology can help companies achieve economies of scale. Producing more units at a lower average cost increases efficiency and profitability.

It is feasible to handle higher levels of debt by investing in larger facilities or cutting-edge technology since they give economies of scale opportunities. When output increases while average unit cost decreases, this indicates increased productivity and profitability.

Enhancing Competitive Edge

Using leverage to meet specific strategic requirements can provide a competitive advantage. To compete with competitors, businesses use cash to implement aggressive market tactics such as strong marketing or price cuts.

Potential Disadvantages and Risks of Financial Leverage

Using or having a lot of borrowed funds does come with multiple benefits, but they may also lead to just as many problems.

Increased Financial Risk

It maximises both profit and risk returns. Even if a company’s financial performance suffers, the debt load requires resolution. This circumstance has the potential to cause a financial crisis. High leverage can result in a scenario in which a corporation is unable to cover the costs of its borrowings, either ordinarily or during economic and business cycle downturns.

Higher Interest Costs

Borrowing money is not for free. It is important to note that interest might accumulate, especially if the borrowed sum is huge. Heavy interest payments can reduce profitability and potentially negate the advantages of leverage. This is why it’s crucial to get loans with ideal terms and conditions. On the other hand, every loan should seek to be acquired on beneficial terms.

Potential for Bankruptcy

In some circumstances, leverage might lead to bankruptcy. This is usually the situation when a corporation fails to pay its dues, which allows creditors to take the firm and liquidate its assets to collect their money. This risk is particularly visible in areas with low and variable income.

Reduced Financial Flexibility

They can decrease a company’s operational flexibility. Because the majority of the income is used to pay off debts, there is less money to spend on other options. This constraint might limit a company’s ability to invest more cash in new initiatives or respond to market demands.

Increased Stock Price Volatility

Leverage leads a company’s stock price to be more sensitive to market pressures. Debt may be viewed as a risk factor by investors, causing the equivalent proportion of the stock price to fluctuate with market trends and corporate performance.

Conclusion

Financial leverage is a major and powerful strategy in financial management that gives a chance to increase profits and expand operations. We learned about the many forms of leverage that exist, such as financial, operating, and combined leverage, all of which are significant instruments for corporate strategy. We also considered major financial leverage ratios, which are used to measure a firm’s leverage and risk profile. Despite the fact that utilising leverage can boost returns on investment and provide additional tax benefits, it also carries a number of hazards, including financial risks, the possibility of incurring more interest charges, and even bankruptcy.

To completely capitalise on its advantages or minimise all of its negatives, leverage in financial management requires effective planning, measures, and control. Knowledge and management of leverage will make a significant difference in terms of making better decisions in the future and achieving economically desirable results. To learn more about Financial leverage and similar concepts, you can consider pursuing the Certificate Program in Financial Analysis, Valuation, & Risk Management.