Leveraged financing refers to the use of borrowed funds, such as debt, to purchase a more expensive asset. Leverage, also known as financial leverage, is an important tool for businesses that can increase their return on investment (ROI) by taking on higher levels of debt.
Leveraged finance is usually used to acquire an asset that the company wouldn’t otherwise have the funds to purchase. When used within the scope of prudent finance, this type of financing can help companies acquire the capital they need to expand and increase profitability.
There are two types of leverage – financial and operational. Financial leverage refers to the use of borrowed funds to purchase an asset, while operational leverage refers to the use of an asset to generate future income and returns.
The concept of leverage is simple: By taking a loan, businesses are able to purchase assets for a much lower total cost than if they were to purchase the asset with money from their own pocket. Conversely, if the asset performs poorly, then the increased debt can lead to increased losses.
In the context of finance, leverage is a double-edged sword; it can both increase a company’s return on investment, as well as its risk. For example, a higher degree of leverage may increase a company’s potential returns greatly, but should the asset fail, the company must repay the loan, resulting in a major loss.
The main drivers of leverage include risk appetite and perceived future returns of the asset. The greater the risk appetite of the company, the higher the leverage theyre likely to take on. Additionally, companies are willing to take on greater leverage if there is a greater expected return from the asset. For instance, a company may take on greater leverage when purchasing a high-growth stock than when buying a low-growth stock.
Other factors that influence the amount of leverage include the quality of the asset in question and limitations on the amount of debt imposed by lenders. High-quality assets are more likely to secure a loan at a lower interest rate, allowing the company to take on more debt and, thus, more leverage. Conversely, low-quality assets may not be able to secure finance at favorable interest rates, limiting the amount of leverage the company can assume.
The risk associated with leveraged financing can be managed by diversifying the assets purchased with the borrowed funds and by forecasting the potential returns of these investments accurately. The risk of loss can also be minimized by liquidating some of the assets in the event of a financial downturn or other unforeseen situation.
In conclusion, leveraged financing is a powerful tool that, when used judiciously, can help businesses raise capital to purchase new assets and/or expand their operations. While there are risks associated with leveraged financing, these can be addressed with proper risk management and diligent forecasting.
