Financial Leverage
Financial leverage refers to the use of debt to increase the potential return on investment. It involves using borrowed funds to finance the operations and growth of a business, with the aim of magnifying profits. While it can amplify gains, it also increases the risk of financial distress if the business is unable to meet its debt obligations.
6 Key excerpts on "Financial Leverage"
eBook - ePub- Brümmer LM, Hall JH, Du Toit E(Authors)
- 2017(Publication Date)
- Van Schaik Publishers(Publisher)
...Nevertheless, the role of capital structure is of paramount importance in both instances of wealth and of maximising profitability. In either instance, a discussion of Financial Leverage becomes necessary. What is Financial Leverage? Financial Leverage may be defined as an organisation’s capacity to use fixed financial costs to magnify the effects of changes in EBIT on EPS. Let us briefly discuss the implications of this definition. Fixed financial costs are the costs that appear in the second half of the Statement of Comprehensive Income – that is, immediately after EBIT. These costs usually consist of the payment of interest and preference dividends. Although income tax is included among the financial costs, the obligation to pay tax is always present but payment is not always enforceable and occurs only when profits are high enough to attract tax. In general, and in terms of capital structure, the most important item among the fixed financial costs is the payment of interest on debt capital. This brings us to the organisation’s capacity to use financial costs to create Financial Leverage – that is, the capacity to make use of debt capital in its capital structure. If EBIT is unstable, then it would be doubtful whether it could adequately cover financial costs, and it would therefore be too risky to include debt capital in the capital structure. In other words, the organisation’s capacity to make use of debt capital would depend on the risk involved. In this instance, we are talking about total risk, which includes operating and financial risk, both of which will be discussed later. The action of the financial lever The positive action of the financial lever may be observed when a certain change in EBIT results in a proportionately greater change in EPS. Instead of using EPS as our criterion, we could also use return on equity (ROE) – that is, return on owners’ equity in this instance...
eBook - ePubCorporation 2020
Transforming Business for Tomorrow's World
- Pavan Sukhdev(Author)
- 2012(Publication Date)
- Island Press(Publisher)
...However, two steps can be taken to improve corporations’ use of leverage. First, we can reevaluate and rebuild the financial sector’s regulatory infrastructure to better monitor systemic risk and control of leverage. Second, we can explore regulatory options for nonbanking corporations that include reasonable limitations on leverage for organizations with substantial exposure to Financial Leverage. Any corporation (be it a bank, a mortgage lender, an insurer, or a car maker) that is considered “too big to fail” is in effect placing public capital at risk, and, for that privilege, it must at least set aside some of its own capital funds as a cushion against unexpected losses. Achieving these two steps will also encourage efficient management of capital raised and will reduce the market economy’s exposure to runaway asset bubbles. The Benefits, Risks, and Costs of Financial Leverage We can define Financial Leverage, in general, as any contract-based mechanism through which an entity gains access to assets by using funds provided by others or by putting at risk a lower amount of its own equity capital. For the average institution, Financial Leverage includes taking out loans, issuing bonds, and leasing assets. However, more sophisticated variations of Financial Leverage include executing bank repurchase agreements (repos), issuing insurance policies or guarantees, and entering structured derivatives transactions. All of these activities greatly magnify the impact of a given amount of equity capital. The downside of leverage is that it also increases the amount of risk and the size of potential losses, because the provider of funds will usually take security or ensure that it has first preference in claims (sometimes referred to as “seniority” of claim) on the assets acquired, if things indeed do go wrong. Leverage enables a corporation to make investments or incur expenses it would not otherwise have been able to undertake, based on its existing resources...
eBook - ePubKickstart Your Corporation
The Incorporated Professional's Financial Planning Coach
- Andrew Feindel(Author)
- 2020(Publication Date)
- Wiley(Publisher)
...Banks take the money we deposit, pay us an interest rate, and then go off and invest in something else, generating a potentially higher rate of return. It's known as the concept of using other people's money (OPM). The most important aspect of leverage is that it is a blade that cuts both ways: it can offer massive financial benefits or become a major financial burden. The key is to use leverage prudently, investing wisely in the appropriate investment accounts within disciplined and certain time frames, and to make sure that it is suitable for your specific risk tolerance. Leveraging can be used to improve your long-term effective rate of return within your corporation assets, or help build your non-registered assets. In this chapter, we explore how leverage can enhance returns in the corporation, assist in removing funds outside of the corporation with offsetting deductions, and make your mortgage tax deductible—but we'll also look at the downside of leveraging. What You'll Get Out of This Chapter In this chapter, we review the ins and outs of borrowing to invest, also known as the use of leverage. We review who is a suitable candidate for the use of leverage, and what products and strategies may allow you to benefit from leverage—and importantly, we also review when and for whom leverage is not appropriate, including some cautionary tales from real-life examples we've seen. You will leave this chapter with a good overview of how to use leverage to your advantage, and when to steer clear. First, let's review the pros and cons of leveraging. Pros of Leveraging It may increase your effective returns. Your investments start working for you right away, as opposed to waiting the time it takes to save the same amounts. Borrowing money to invest allows you to create a tax deduction for interest costs. Behavioural finance principle: Leverage creates a forced savings plan, which forces you to be disciplined in your saving, perhaps resulting in less impulsive...
eBook - ePub- Debi J Peverill(Author)
- 2018(Publication Date)
- Painless Financial Training Group Inc.(Publisher)
...Chapter 13. Why You Should Borrow Money A business borrows money for at least two reasons: to take advantage of leverage—using other people’s money to make money for your business; and capital purchases—the business does not have the funds to purchase an asset that will be of use for a number of years. If either of these situations applies to your business, then you should look into borrowing money. The personal example we have used before in this book is the purchase of a home. Many people buy homes using a mortgage. They pay down the mortgage and eventually own the home. In this way, they have paid for an asset over time that they could not have afforded to buy all at once. This is a key point about leverage. A prudent business owner uses debt to increase the equity in a business over time. In the home example, is easier to live in a home and make payments than it is to pay rent and try to save money. Leverage is a great idea if you invest in a profitable business and a bad idea if all it does is allow you to spend more money on ideas that do not work. As with many business decisions, it is important to be psychic—to be able to see ahead and decide if the plan is going to work. There is no substitute for psychic ability, although much has been written about market research and business plans. We should never lose sight of the fact that when we begin to predict the future we are still just making stuff up. Leverage An example will help to illustrate the concept of leverage. Think of yourself as wanting to be in the pencil business. You see a market, but you have no money to buy product. Let us imagine that you have talked a supplier into giving you the pencils and you will pay the supplier later. In the first table, you see the effects of the transaction where the pencils are purchased. The balance sheet shows inventory and accounts payable. Table 21. Step one: Purchase of pencils As you can see, no money has been made simply by purchasing the pencils...
eBook - ePubThe Art of Being Unreasonable
Lessons in Unconventional Thinking
- Eli Broad(Author)
- 2012(Publication Date)
- Wiley(Publisher)
...Chapter 10 Leverage If you have ever bought anything on credit, you’ve used leverage. Let’s say you put some money you had saved down on a car and finance the rest. With the loan, you have to pay five years of interest—not an inconsiderable sum. But you get the car right away, and all the opportunity it brings: picking up your date, taking a road trip, and of course, driving to your job to make the money you need to pay off your car loan. The car may not be “worth” the money you paid plus interest—certainly not after you’ve driven it around for five years—but living without a car carries its own costs. Without the loan, you would have whatever amount you had for a down payment, but you would have to spend at least a few years saving up the rest of the car’s purchase price. And you would probably be taking the bus—making it that much harder to do everything you want to do, including making a living. The loan is your leverage—it’s what enables you to do more with your money. But leverage isn’t always money. Sometimes it’s about channeling your energy and effort, enlisting the help of your friends and colleagues, applying technology, working with the press or social media, or mentoring someone who goes on to mentor 10 more people. I’ve used leverage to increase capital for my businesses, but I’ve also used it to get the most out of my marketing, to raise funds for civic initiatives, and to do more in philanthropy than we possibly could have with our money alone. Think of the literal meaning of the word leverage. It refers to levers—tools that amplify your power to move something. They’re everywhere, and you should always use them when you can. Some Straight Talk About the Mother of All Loans—Your Mortgage Buying a home using a mortgage is the best opportunity most people have to leverage their money. I recognize the reluctance to get a mortgage...
eBook - ePubThe Value of Debt
How to Manage Both Sides of a Balance Sheet to Maximize Wealth
- Thomas J. Anderson(Author)
- 2013(Publication Date)
- Wiley(Publisher)
...Proper design and implementation of the company’s capital structure—and their overall debt philosophy—is a key part of these expectations. Interestingly, there are some theories out there that say companies should be almost 99 percent debt and 1 percent equity! 11 Nobel Prizes have been awarded for the theories with respect to corporate finance and the optimal corporate capital structure. It is important that we are familiar with that work and consider its potential implications on our personal lives. If you are a CFO of a public company and you haven’t focused on your optimal debt ratio, do you know what you could be? That’s right: You could be fired! Consider, then, for a moment, what the role of the CFO in a company is. He or she starts by taking a holistic approach to the company’s balance sheet. This begins by considering the corporation’s total assets and the likelihood of the company encountering financial distress, along with what the fallout of that financial distress would be in terms of direct and indirect costs, the impact level of that financial distress, and its duration. (See Chapter 2 for a description of these terms and dynamics.) With all this in mind, the CFO then determines the cash flow needs of the organization, and then looks at how much debt the company should have in terms of accessing the indebted strengths of Increased Liquidity, Flexibility, Leverage, and Survivability. Structuring the right amount of debt in the right way is critical, because if the company takes on too much risk in the form of increased debt then it could go bankrupt. If it doesn’t take on enough of the right kind of debt then it may not be maximizing value and/or may increase the chances of either running into a liquidity crisis or being bought out by a hostile party...
