Introduction
Financial leverage, which can be referred to as gearing, is the use of borrowed funds to increase the return on equity of a business. The leverage ratio measures the degree to which a company is utilizing borrowed funds. It can be calculated in terms of debt and equity, as well as in terms of assets and equity. The higher the leverage ratio, the greater the use of debt and more risk the company is taking on.
Calculation
The most common way to measure financial leverage is through the use of the Debt to Equity Ratio. This ratio is calculated by dividing a company’s total liabilities (debt) by its total equity. A higher ratio implies that the firm has more debt relative to its equity and is thus said to have greater financial leverage. For example, a Debt to Equity Ratio of 2 would indicate that the firm is utilizing two times as much debt as equity in financing its operations.
Types of Financial Leverage
Financial leverage can be broken down into two main categories: operating leverage and financial leverage.
Operating leverage is the use of long-term debt within the operations of a business. Operating leverage involves the companys use of debt to finance the purchase of assets needed to produce goods and services. This debt increases the operating costs of the business and can lead to higher profits or losses depending on how it is managed.
Financial leverage, on the other hand, involves the use of debt to finance investments in other companies, such as stocks and bonds, or to purchase assets with higher expected returns than those of the issuers own business. Financial leverage can be thought of as a way for investors to achieve greater returns than would otherwise be possible by taking on additional risk, as the returns on leveraged investments can be higher than investments made with only the investors own money.
Advantages and Disadvantages
The use of financial leverage can provide companies with several advantages, as well as some possible disadvantages. The primary benefit of leveraging is that it increases the return on the company’s investments, as well as its potential for growth. By borrowing funds and investing the proceeds in projects that are expected to generate greater returns than the costs of the loan, a company can increase the amount of wealth it generates.
However, leveraging can also have some negative consequences. If the returns on the leveraged investment do not match the expectations of the lenders, the company can be left with significant debt and higher operating costs. Also, the higher levels of risk associated with financial leverage can lead to volatility in the company’s cash flows, making it difficult to plan for the future.
Conclusion
The use of financial leverage can provide companies with significant advantages when it is used properly. It can increase returns on investments and provide an opportunity for increased growth. At the same time, however, it can also increase the risk associated with a company’s investments and lead to volatility in its cash flows. Companies should take time to understand the nuances of financial leverage and make sure they are making sound decisions when utilizing it.
