Financial Leverage and Risk

The use of debt to fund investment in a company’s assets is called financial leverage, an important concept that should be understood because of its effect on return on investment (ROI) for equity holders, as well as the risk it introduces for both lenders and investors.

As mentioned above, creditors, while having legal claims against assets of a company, do not share in profits or losses. This benefits equity investors because they do not suffer dilution of ownership share when debt is added, nor do they share profits with creditors during good times. This has a magnifying effect on investor ROI. This favorable leverage effect, however, works both ways and during downturns in your business or the economy, leverage magnifies the losses incurred by investors.

The use of debt financing has, because of this leverage, introduced volatility, and therefore risk, that investors must face. Because creditors rely on a company’s solvency to provide for debt service and ultimate repayment, creditors also face increased risk from the added leverage.

Remember that just as creditors do not share in profits, they also do not share in losses, but interest and principal are fixed costs to the company that must be paid, regardless of profitability, to avoid default and bankruptcy.

Before deciding on how much debt to add to the balance sheet, it is important to forecast different financial scenarios that include the possibility of a business downturn, or worst-case scenario. Then it can be determined if the leverage under consideration will place the company at risk of insolvency.

Matching Debt to Assets

While excessive debt loads can often be identified with ratio and trend analysis, it is also important to apply the proper type of debt to the intended use of that debt.

One mistake often made is to mismatch the term of debt to the intended use of the borrowed funds. Simply put, long-term assets should be funded by long-term debt. If short-term debt with high interest and short repayment terms are used to finance capital equipment, for example, with a long lead time to achieve production, then cash flows generated by that long term asset will not be available soon enough to repay the debt and that burden will be placed on other operations.

Such capital equipment is better financed with long term loans or capital leases that better match the payout period with the payback period of the project. Similarly, short term funding needs are better suited to short term debt such as trade payables, credit lines, or even, in some cases, credit cards with monthly payoffs. Using up long-term credit sources on short-term assets can result in an inability to obtain debt funding for long-term projects when the need arises. Again, opportunity costs need to be considered when using finite funding sources.

Author: Marc J Marin

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