Leverage

What Is Financial Leverage?

In business, financial leverage is the use of borrowed capital — generally as corporate bonds or loans — to finance operations to generate income.
To fill in value, companies need to hire, expand, conduct research, develop new products and services, purchase equipment, and lease warehouses and offices. On the off chance that a company does not have enough cash on hand to finance these activities, it must either issue additional equity (stock) or borrow money.
Companies "leverage" borrowed capital by utilizing it to generate income and increase the value of the business. The more money a company borrows, the more "leveraged" it becomes. Ideally, the income generated from the use of borrowed capital should exceed the cost of borrowing it (i.e., interest payments). The more a company's debt-generated income exceeds its cost of borrowing, the more effectively it is utilizing leverage.

For what reason Do Businesses Use Leverage?

When a company issues common stock to raise money, it gives up a portion of its ownership to shareholders. When a company issues corporate bonds or takes out a loan, then again, putting resources into new projects without relinquishing any ownership is able. When a company's debt-financed investment takes care of by increasing income, the company's return on equity (ROE) increases because it didn't issue additional equity to support income.

How Do Businesses Use Leverage?

When companies sell corporate bonds or take out loans, they do so to fund specific income-generating projects. As mentioned above, common uses of debt financing include hiring, the purchase of assets like plants or equipment, research and development efforts, and even marketing. Additionally, debt financing might be used to acquire other businesses whose assets can be incorporated into the company's income-generating strategy.

Financial Leverage Example

An east coast-based beverage company whose beverages were sold in stores and restaurants across the country could use leverage as a corporate loan to finance the purchase of a new beverage production and canning plant on the west coast to reduce the cost of transportation its inventory across the country.
By utilizing a loan instead of giving new shares, the company would not relinquish any additional ownership to stockholders. Ideally, the money saved on transportation would outweigh the cost of borrowing money to purchase the new plant in the long term, resulting in increased income for the company and a higher return on equity.

How Is Financial Leverage Measured?

Most investors and analysts evaluate leverage utilizing leverage ratios, which express the degree to which a company's operations or assets are financed by debt. Several leverage ratios exist, yet the most well known is the debt-to-equity ratio.

Well known Leverage Ratios Used by Investors

• Debt-to-Equity (D/E) Ratio: The debt-to-equity ratio (calculated by dividing a company's total debt by its shareholders' equity) is a great method for looking at the amount of what a company possesses and does is financed with borrowed money versus hope much is financed through investor dollars.
• All debt to-Total Assets Ratio: The debt-to-total assets ratio (calculated by dividing a company's total debt by the value of its assets) permits investors to understand which percentage of a company's assets (e.g., plants, property, equipment, and intangible assets like goodwill and intellectual property) were financed with borrowed money.
• Debt-to-Capital Ratio: The debt-to-capital ratio (calculated by dividing a company's total debt by its total capital) offers knowledge into a company's capital structure by outlining a company's debt as a proportion of its total capital (i.e., debt plus equity).

The amount Leverage Is Healthy for a Company?

In general, a debt-to-equity ratio of around 1 and a debt-to-total assets ratio of around 0.5 may be considered "normal." That being said, how much leverage is considered healthy varies quite a bit between industries, and some sectors (e.g., banking) use leverage undeniably more than others. Hence, looking at the leverage ratios of an automotive company to those of an internet company wouldn't be very meaningful.
Inside an industry, however, in the event that a company is significantly more leveraged than its peers, it is likely a riskier investment, as its potential for default is higher. A company that is substantially less leveraged than its peers, then again, could be considered a safer investment inside its industry.
When evaluating leverage, company age is additionally an important factor. It is normal for startups and younger companies in growth phases regularly finance a large number of their assets and operations with debt, so high leverage ratios shouldn't necessarily scare investors off when it comes to newer, smaller-cap growth companies.

Highlights

• Leverage refers to the use of debt (borrowed funds) to intensify returns from an investment or project.
• Investors use leverage to duplicate their buying power in the market.
• Companies use leverage to finance their assets — instead of giving stock to raise capital, companies can use debt to invest in business operations trying to increase shareholder value.