The Financial Leverage Effect
Financial leverage is the use of borrowed funds to acquire additional assets, which can lead to higher returns when profits are generated. The degree of financial leverage can be interpreted as the amount of capital acquired through debt relative to the amount of capital acquired through equity. In general, businesses will employ financial leverage to increase their profitability because debt is usually cheaper than equity. The financial leverage effect is an increase in return on capital as a result of financial leverage.
The financial leverage effect has both positives and negatives depending on the situation. A business with low financial leverage and stable profit will experience a positive financial leverage effect due to the use of debt which allows it to increase its asset base and increase its returns. Increased sales and more capital can generate more profit. However, the negative aspect of financial leverage can come into play if a company has too much debt or if its financial situation becomes unstable. If a company’s profits decrease or if it is unable to cover debt servicing costs, lenders may demand their money back and the company may be forced to liquidate assets in order to pay its debts. This can have dire consequences for companies which have leveraged too much.
The financial leverage effect is an important concept for businesses to consider when determining their optimal level of borrowing. Different businesses can tolerate different levels of financial leverage, depending on their risks and capital needs. For example, a business which is engaged in highly cyclical activities and has wide swings in its profits, may need to limit its financial leverage to avoid experiencing negative financial leverage effects. Conversely, a company which is stable and has consistent profitability may choose to leverage more in order to increase its returns.
It is important to be aware of the financial leverage effect, as businesses can maximize their profits by leveraging to the right level, while avoiding excessive debt levels which can lead to major problems in downturns. Wise use of financial leverage can be a critical tool for businesses looking to maximize their returns, but it is also important to understand the risks associated with excessive leverage.
