Introduction
Financial leverage refers to the amount of debt used to finance a company’s assets, investment, projects or other aspirations. The impact of utilizing financial leverage in a company can either bring about negative or positive results. Investments are the determining factor in the growth, economic and social success of a company. Financial leverage can either increase the company’s risks of going bankrupt since those who own common shares are exposed to financial risk or immensely increase the company’s profits and returns (Keown, Martin, & Titman, 2017). The whole idea behind getting a loan to finance a certain aspiration revolves around the notion that the money borrowed will be amplified into greater value for the firm (Keown, Martin, & Titman, 2017). In short, the higher the ration of borrowing to equity, the greater the degree of leverage. Notably, favorable or positive leverage occurs whenever the rate of return on assets exceeds the cost of borrowing (Keown, Martin, & Titman, 2017). Unfavorable or negative leverage occurs when the cost of borrowing is greater than the return on assets (Keown, Martin, & Titman, 2017). The ensuing discussion expounds the terms favorable or unfavorable leverage.
Financial leverage is considered to be favorable on the occasion that the firm successfully makes profits on the investment or products purchased with the fixed costs. Nowadays, most firms are willing to take bankruptcy risks in order to make profits (Carlson, 2019). A more suitable approach to understanding favorable financial leverage is taking the instance of a home owner. Currently, most people are utilizing financial leverage to buy their dream homes. Most mortgages made using financial leverage are favorable; however, they are dependent on two factors (Keown, Martin, & Titman, 2017). The first one is the ability of the homeowner to pay his monthly payments. The second factor depends on whether the asset gains value, which would as such magnify financial leverage. If these two factors are not met, the financial leverage becomes unfavorable leading to repossession of the property.
Delegate your assignment to our experts and they will do the rest.
Financial leverage can also be considered unfavorable in the occasion that the company fails to make the anticipated profits on the funds it borrowed. Changes in EBIT can lead to greater variations on EPS and the total earnings available to the common shareholders if a company chooses to use financial leverage (Keown, Martin, & Titman, 2017). Higher financial leverage makes it harder to pay debt, which can lead to bankruptcy. Companies with high financial leverage are also considered to be very accountable on the way funds are spent. This caution is due to the high accountability levels that creditors and lenders expect from companies they conduct business with (Keown, Martin, & Titman, 2017).
A fitting example of unfavorable leverage is a factory that has assets worth $1 million. The assets produce an annual income of $100,000, which places the return on assets at 10%. If the assets are fully financed through equity from shareholders, the return on equity is 10%. However, the finance can also come from a bank loan. In this case, consider the assets are financed equally between debt and equity, that is, both contribute $500,000. The return on assets reduces to 8% while the return on equity rises to 16% (Nissim & Penman, 2015). Now consider if the shareholders contribute $100,000 and the rest of the $900,000 is acquired through a loan, the return on assets reduces to 6.4% since annual net income is $64,000 (Nissim & Penman, 2015). The return on equity rises to 64%. If the annual net income fails to return $64,000 and makes a loss of $200,000, the finance on equity is completely wiped out which leads the bank to repossess the company’s assets to pay off the debt (Nissim & Penman, 2015).
Conclusion
Leverage as discussed is a method of corporate funding that evaluates the ratio between the assets and returns to the debts and equity utilized to finance the investment. Notably, it can be favorable or unfavorable, and it emanates from the decision to finance operations with debt instead of equity. It has also been utilized in financing mortgages, investment portfolios and buying companies. During the Great Depression, financial leverage was highly discouraged since it was expected to lead to bankruptcy of businesses. However, this notion has changed since more firms are willing to take the risk and earn more. Leverage should be treated with caution since borrowed funds can only produce greater returns if they are managed appropriately and utilized in a worthy cause.
References
Carlson, R. (2019). What is Leverage? The Balance Small Business.
Keown, A., Martin, J., & Titman, S. (2017). Financial Management: Principles and Applications (13th ed.). New York: Pearson Publishers.
Nissim, D., & Penman, S. (2015). Financial Statement Analysis of Leverage and How It Informs About Profitability and Price-to-Book Ratios. Graduate School of Business: Columbia University , 1-45.
