The Consequences of Financial Leverage
Financial leverage refers to the ability of an individual, company or organization to use borrowing funds to gain ownership in a business or to acquire additional assets for the purpose of achieving greater return on investments. This is often done through the purchase of stock or other investments that have the potential for higher returns than what is currently available on the market. Leverage can be used either positively or negatively depending on the strategy being employed to maximize the return, and the amount of risk being taken on.
Positive
One of the primary benefits to using financial leverage is the potential to increase returns on investment. Through the judicious use of borrowed funds, an organization can achieve higher return on investments than if the same funds were invested without leverage. By creating leverage through the acquisition of more assets or capital, the organization can increase its return on investments while at the same time lowering the total costs of any existing holdings due to utilizing the debt as a form of financing. This allows the organization to achieve higher levels of return while also freeing up its existing capital for other areas of investment.
Negative
Although leveraging can be useful when done correctly, it also has dangers associated with it. The most dangerous aspect of leverage is in its ability to lead to over-indebtedness. If the organization relies too heavily on debt financing to support their investments, or if the amount of leverage exceeds the organizations ability to service the debt, this can lead to an increase in losses on the investment or to a complete or partial default on the loan.
The second danger associated with leverage is the potential for an organization to overextend itself by taking on too much debt or too many investments. This could lead to a decrease in the return on investments and an erosion of the company’s liquidity.
Finally, a company that is too heavily leveraged could be subject to unfavorable market conditions if the market fluctuations cause a sharp drop in the value of their investments or assets. In such a scenario, the organization may find itself unable to service its debt payments, leading to a default or complete loss of their loans.
Conclusion
Financial leverage can be a powerful tool for organizations that seek to increase their returns on investments. However, it can also be very risky if used incorrectly or without proper planning. Organizations that plan to use leverage should be aware of the potential risks, and take the time to decide whether this type of investment is right for their individual situation.
