Debts can be a headache or an opportunity for the finances of a company, we have already mentioned it before. Therefore, there are conflicting opinions regarding the effectiveness of financial leverage, since depending on the financial status of the company, it will imply the possibility of an improvement or an undesirable and avoidable risk.
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To answer these questions, in this article, we set out to highlight the advantages and disadvantages that financial leverage can cause in an organization and what is the real impact that it can generate on its profitability.
As you will understand, each source of funds has its advantages and disadvantages. The interest on the borrowed money is tax-deductible, while dividends and distributions paid to shareholders are after-tax distributions. In addition, the interest rate is usually lower than the rates of return demanded by investors in shares.
In this sense, since the cost of debt money is less than the required return on capital, why not ask for a loan? The answer lies in understanding the effects of financial leverage.
In previous articles, we have defined financial leverage as the ratio of a company's debt to its equity capital. This metric is known as the debt-to-equity ratio.
What are the effects of financial leverage?
The goal of a small business owner is to maximize the return on equity, ROE, from both the owner's money and the capital of outside investors. One way to do this is to minimize the cost of financing the business.
Suppose the interest rate on your company's debt is 8% and investors require an 18% return on their equity. With a capital base of $400,000, the company needs to earn a net income of $72,000 on $1 million in sales to achieve an 18% return on capital.
What would happen if the total debt of the company increased to $600,000 and the equity was reduced to $200,000? Net income would drop to $60,200 due to the higher interest cost of more debt, but look what happens to ROE. The ROE is now:
ROE = Net income / Equity capital = $60,200 / $200,000 X 100 = 30%.
The debt-to-equity ratio increased to 3:1 ($600,000/$200,000). What are the limitations of leverage?
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Advantages of financial leverage.
We can find some notable advantages through financial leverage if we want to extract some economic benefit and short-term growth from debt. These are the main ones:
- Unleash the potential of finance. Choosing this alternative allows you to go much further than would be possible without this financial practice.
- Aumenta la tasa interna de retorno (TIR) de la operación. Debido al apalancamiento, la de los fondos propios se dispara. Esto no significa que se gane más dinero en valor absoluto. Increases the internal rate of return (IRR) of the operation. Due to leverage, the financial return on equity skyrockets. This does not mean that more money is made in absolute value.
- It allows you to achieve specific goals in the short term. It is suitable for short periods in which you are looking to achieve some kind of growth or profit.
Based on the example above, increasing the debt-to-equity ratio substantially increases investors' return on equity. This way, we can understand that the ROE went from 18% to 30%, so investors would be very pleased. They have less money at risk and instead get higher returns.
Now, what would happen if the economy went down and sales went down?
Disadvantages of financial leverage.
But just as it can fuel relatively rapid economic growth, running financial leverage can also carry a high risk of financial loss. Let's see what can affect its implementation.
1. It increases the financial risk.
Debt is a source of financing that can help a business grow faster. Financial leverage is even more powerful, but a higher-than-normal level of debt can put a company in a leveraged state that is too high, magnifying risk exposure.
2. It is more expensive for the company.
Leveraged financial products, such as leveraged loans and high-yield bonds, pay higher interest rates to compensate investors for taking more risk.
3. It is a complex operation.
The financial instruments involved, such as subordinated intermediate debt, are more complex. This complexity requires additional management time and involves several risks.
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Financial leverage: cost or solution?
It depends. If the economy is good and sales are growing, then higher financial leverage results in a higher return on capital, and that's a good forecast. However, financial leverage has a knock-on effect.
If sales decline, the business can quickly run into losses and face the possibility of defaulting on loan payments, which is bad. As a small business owner, you need to understand the pros and cons of financial leverage and decide how much financial risk you're willing to take in times of economic uncertainty.