Financial Leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company’s bottom-line earnings per share.
Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company’s capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.
When purchasing assets, three options are available to the company for obtaining financing: using equity, debt, and leases. Apart from equity, the rest of the options incur fixed costs that are lower than the income that the company expects to earn from the asset. In this case, we assume that the company uses debt to finance the asset acquisition.
Example
Assume that Company X wants to acquire an asset that costs $100,000. The company can either use equity or debt financing. If the company opts for the first option, it will own 100% of the asset, and there will be no interest payments. If the asset appreciates in value by 30%, the asset’s value will increase to $130,000 and the company will earn a profit of $30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000 and the company will incur a loss of $30,000.
Alternatively, the company may go with the second option and finance the asset using 50% common stock and 50% debt. If the asset appreciates by 30%, the asset will be valued at $130,000. It means that if the company pays back the debt of $50,000, it will remain with $80,000, which translates into a profit of $30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000. It means that after the paying the debt of $50,000, the company will remain with $20,000 which translates to a loss of $30,000 ($50,000 – $20,000).
Risks of Financial Leverage
Although financial leverage may result in enhanced earnings for a company, it is also likely to result in disproportionate losses. Losses may occur when the interest expense payments for the asset overwhelm the borrower because the returns from the asset are not sufficient. It may occur when the asset declines in value or interest rates rise to unmanageable levels.
(i) Volatility of Stock Price
Increased amounts of financial leverage may result in large swings in company profits. As a result, the company’s stock price will rise and fall more frequently, and it will hinder the proper accounting of stock options owned by the company employees. Increased stock prices will mean that the company will pay higher interest to the shareholders.
(ii) Bankruptcy
In a business where there are low barriers to entry, revenues and profits are more likely to fluctuate than in a business with high barriers to entry. The fluctuations in revenues may easily push a company into bankruptcy since it will be unable to meet its rising debt obligations and pay its operating expenses. With looming unpaid debts, creditors may file a case at the bankruptcy court to have the business assets auctioned in order to retrieve their owed debts.
(iii) Reduced Access to More Debts
When lending out money to companies, financial providers assess the firm’s level of financial leverage. For companies with a high debt-to-equity ratio, lenders are less likely to advance additional funds since there is a higher risk of default. However, if the lenders agree to advance funds to a highly-leveraged firm, it will lend out at a higher interest rate that is sufficient to compensate for the higher risk of default.
(iv) Operating Leverage
Operating leverage is defined as the ratio of fixed costs to variable costs incurred by a company in a specific period. If the fixed costs exceed the amount of variable costs, a company is considered to have high operating leverage. Such a firm is sensitive to changes in sales volume and the volatility may affect the firm’s EBIT and returns on invested capital.
High operating leverage is common in capital-intensive firms such as manufacturing firms since they require a huge number of machines to manufacture their products. Regardless of whether the company makes sales or not, the company needs to pay fixed costs such as depreciation on equipment, overhead on manufacturing plants, and maintenance costs.
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