Financial leverage is the term used in the context of financial markets, it refers to the use of borrowed funds by the company to acquire assets for business which results in amplification of both profits as well as losses done by the company. In order to get a better idea about this concept, one should look at some of the important characteristics of financial leverage –
Financial Leverage Characteristics
Cost of Funds is Fixed
When a company raises capital through debt than cost of funds will be fixed because whether the company takes a loan from a bank or raise money through debentures the terms of the loan are fixed, hence for example if the company has taken a loan of $100000 at 8 percent than the company will have to give $8000 per year whether company earns profit or loss during the year.
Returns are Unpredictable
Another feature of financial leverage is that if the company is using financial leverage than returns can be unpredictable because both profits, as well as losses, are magnified. It can be better understood with the help of an example, suppose a company has taken a loan of $100000 for a $200000 at 8 percent and invested that money into a project of $200000 and from that project if the company earns 30 percent return after all the expenses than the company will earn $60000 from the project hence company rate of return will be 60 percent on invested capital due to leveraging, however, if the company loses 30 percent than it will result in loss of $60000 on invested capital resulting in loss of 60 percent invested capital.
Funds to be Invested in Projects or Assets
Another feature of financial leverage is that funds are borrowed by the company have to be invested in new assets or projects which are assumed to general higher return than the cost of borrowing. Hence a company cannot be said to be doing financial leverage if the company is raising debt to pay dividends to shareholders or salaries to its employees or paying its operating expenses.
Ratios to be kept in Mind
While analyzing the financial leverage companies should focus on some ratios which are the debt-equity ratio which is the ratio of debt to owners funds a higher ratio would mean the company has more debt and less owner’s capital which is not a good thing in the long term. The interest coverage ratio is another important ratio as far as financial leverage is concerned, interest coverage ratio refers to the ability of the company to service its interest cost from its profits, a lower ratio would imply that the company is not earning enough profits to services its interest payments hence higher the ratio better it is as far as financial leverage of the company is concerned.
Tax Benefit
Debt and liabilities are tax-deductible expenses and hence in a way financial leverage reduces the tax burden of the company and thus in a way helps the company in two ways one by increasing the profits due to the leverage factor and another by reducing the tax liability of the company.
Dependent on External Factors
Financial leverage is not something that is internal to the company rather it is dependent on many external factors like government policies, economic growth, investors sentiment, and other such factors. 2020 gave us the best example about how external factors can lead to problems for companies, we all know that due to coronavirus all over the world lockdown was imposed which lead to the total collapse of demand in many sectors and if in this environment a company has taken the higher amount of financial leverage than it will create big problems for the company as far as the financial position of the company is concerned.
As one can see from the above features of financial leverage that it is a double-edged sword and that is the reason why any company thinking of taking financial leverage should think 10 times before going ahead with using financial leverage in the company because if anything does not go according to the plan of the company than financial leverage can put the company on the brink of bankruptcy.