Why is financial leverage so important for businesses?
The financial leverage effect is often used by companies when they do not have enough equity for an investment and have to borrow money for it. They expect a greater return from the investment than they have to pay back in interest for the loan. Here we show you exactly how the financial leverage effect works and how companies can best use it.
Financial leverage is the borrowing of money to acquire a particular asset that promises a higher return than the interest on the loan that must be repaid. Thus, financial leverage is an investment strategy that helps companies grow and expand, for example.
It is important for companies to assess whether a planned investment is worthwhile and will bring in the desired returns so that no deficit occurs. A risk and profitability analysis is therefore necessary for large investments so that the company does not make an expensive bad investment.
The more borrowed money a company has, the greater the financial leverage it uses. The leverage effect is particularly pronounced in the case of start-ups, as they have hardly any equity capital and are financed almost entirely from borrowed capital.
Financial leverage can be calculated in different ways - depending on what you are interested in. A ratio to a certain reference value is always formed.
The debt-to-equity ratio is the ratio of total debt to total equity: D/E ratio = Total debt / Total equity
Total debt consists of the following Total debt = Short-term debt + long-term debt
Short-term debt is debt with a maturity of one year or less; long-term debt has a longer maturity.
The debt-to-equity ratio indicates how high the shares of debt and equity of the company are. If the company has more debt than equity, the D/E ratio is greater than 0. If the company has more equity than debt, the ratio is less than 0.
If you put the debt in relation to the total assets that were acquired with the borrowed capital, you get the debt-to-assets ratio:
D/A ratio = Total debt / total assets
If the D/A ratio is very high, it means that the company has taken on a lot of debt to invest in assets.
A company expands and opens another location. For this it must Invest £1,000,000 in land, property and equipment for the new site. As it does not have enough equity, it takes out a bank loan of £800,000 at an interest rate of 5%. It therefore has £840,000 of debt to repay in the future.
His total equity after the investment is still £1,500,000. There are no other loans and the amount of total company assets after the investment is £2,500,000.
Now we calculate the financial leverage: Debts-to-equity ratio = £840,000 / £1,500,000 = 0.56 = 56%
Debts-to-assets ratio = £840,000 / 2,500,000 = 0.336 = 33.6%
The debts-to-equity ratio indicates that 56% of the capital is borrowed. The debts-to- assets ratio indicates that 33.6% of the company's total assets are financed with debt.
As you can see from the examples above, financial leverage shows the ratio of debt to total capital or assets. Leverage enables companies to make investments that they could not (or would not) afford due to a lack of equity.
If a company's financial leverage is very high, it means that a large part of its assets or capital is financed by debt. Then the risk also increases, because if the company no longer has sufficient revenues and the investments fall short of their expected returns, the company can no longer repay its debts. In this case, insolvency looms.
If companies use the financial leverage effect correctly, they can invest in their growth even if they do not have enough equity capital at the moment. In this way, companies drive their innovations, expand and set themselves apart from the competition.
Borrowing money to promote growth is therefore common practice in all industries.
However, as mentioned above, financial leverage also entails risks. Especially if the majority of the assets are financed with debt capital, which is the standard case for start-ups. If the business does not develop as expected, a company can quickly get into financial difficulties because it can no longer repay its loans.