According to Physics, leverage is the force needed to lift and, if necessary, move loads. Leverage in finance works in similar
ways as it works in physics. It amplifies the return.
Financial Leverage:
Understanding the Power of Borrowed Funds
Financial leverage is a
strategic approach used by both individuals and businesses to potentially
enhance returns on investments. Here’s what you need to know:
1.Definition:
o Financial
leverage involves using borrowed funds (such as loans or debt) to invest in
assets, with the expectation that the gains from those assets will exceed the
cost of borrowing.
o Essentially,
it’s about borrowing money to make more money.
2.How It
Works:
o Imagine
a company that wants to expand its operations but lacks sufficient equity (ownership
capital) to fund the expansion.
o Instead
of relying solely on its own funds, the company borrows money (e.g., through
loans or issuing bonds) to finance the expansion.
o By
doing so, the company aims to generate returns from the new assets that exceed
the interest payments on the borrowed funds.
o Let us
do the mathematics:
Suppose a
company/individual investing 100 rupees can earn 20 rupees return. Suppose
further interest rate is 8%. Now if the investor borrows 100 and invests 100
rupees of his own, he will be able to earn 40 rupees on his combined capital of
200 Rupees. But he must pay 8 Rupees interest as well. Thereby after returning
the borrowed funds and paying off the interest the investor made 32 rupees
profit using his 100 rupees.
3.Benefits:
o Financial
leverage allows businesses to:
§ Accelerate
growth: By leveraging borrowed capital, companies can invest in projects,
acquisitions, or new ventures.
§ Amplify
returns: If the investment performs well, the gains are magnified due to the
borrowed funds.
§ Optimizes
the capital structure: Balancing equity and debt helps optimize the overall
cost of capital – i.e. keeps the overall cost of capital to minimum.
4.Risks
and Considerations:
o While
financial leverage can boost returns, it also increases risk:
§ If the
investment doesn’t perform as expected, the company still has to repay the
borrowed funds.
§ High
leverage can lead to financial distress if interest payments become
unmanageable.
§ Leverage
amplifies both gains and losses, so it’s crucial to assess risk tolerance.
5.Leverage
Ratios:
o Common
leverage ratios include the debt-to-equity ratio and the debt-to-assets ratio.
o These
ratios help evaluate a company’s reliance on borrowed funds and its ability to
cover debt obligations.
6.Personal
Leverage:
o Individuals
also use leverage (e.g., mortgages for real estate) to invest in assets like
homes or stocks.
o The
goal is to benefit from asset appreciation while managing debt responsibly.
Financial leverage isn’t
inherently good or bad—it depends on the context, risk appetite, and the
specific situation. Whether you’re a business owner or an investor,
understanding leverage is essential for making informed financial decisions
