Leverages in Financial Trading: The guide outlines the meaning of financial leverages, how it works and the factors of risk associated with it. These financial work Debt, Equity and Asset looks small but carry deep meaning along with them.
Financial leverage refers to using debt money or borrowed money to purchase an asset. This asset is purchased with an expectation that it will make a profit or capital gain which will be more than the cost of borrowing.
It is the debt provider who set a limit on the outstretch of the leverage he will allow, and the extent of risk he is ready to take on the asset provided by him.
If we consider the case of asset-backed lending, the seller of the asset will use it as collateral until the money of the loan is repaired. Here collateral refers to the pledge of loan repayment that the borrower makes to the finance provider. Considering another case of cash flow loan, the company uses the general creditworthiness to back the loan.
Financial Leverages contain three main terms:
Asset: It is the resources which one purchases with the expectation that it will give them better profit in future.
Equity: The amount returned to the shareholders of the company when all the debts paid off. It is also known as shareholder’s equity.
Debt: It is a method followed by many cooperatives for purchasing the assets that they can’t afford in normal conditions.
How Financial Leverages Work
There lie three options with the company before purchasing assets for financing: leases, debt and using the equity. Leaving equity, rest all the options incur a higher fixed cost from the firm. This cost is even higher than the value a company expects to earn from the purchasing asset.
In such a situation, the company will use debt money to finance asset acquisition.
Assume that a Firm A wants to purchase an asset costing $100,000. To fulfil the purpose, he can use either debt financing or equity.
Assume, if the firm opts for the first option, and finance the asset using 50% debt and 50% common stock. If asset value appreciates by 40%, then the total worth of the original asset will become $140,000. The overall profit for the company, in this case, will be $40,000, after deducting the debt of $50,000 that it will payback. Similarly, if the value of the original asset depreciates by 40%, then it will become $60,000. In this case, the company will bear a loss of $40,000 (deducting the debt cost from the overall depreciated value of the asset).
Alternatively, if it opts for the second option, it will get 100% ownership of the asset without paying any interest payments.
If the asset value appreciates by 40%, then the company will earn $40,000 profit on the original cost, making the total value of $140,000. Similarly, if the value depreciates 40%, then the company will be in the loss of $40,000, decreasing the value of the original asset to $60,000.
Measuring Financial Leverage
The instruments used to measure the value of leverage are:
Debt to equity ratio: It is used to calculate the proportion of financial leverage of a unit. It also represents the proportion of the company’s equity concerning debt.
The figure for debt to equity ratio helps the management team, shareholders, stakeholders and lenders to understand the level of risk that the company’s capital structure will bear.
To determine this ratio, we use the formula:
Debt to equity ratio = Total debt / Total equity
Total debt includes short term liabilities and long term liabilities.
Short liabilities means the debts that the company will pay within a year.
Long liabilities means the debts that the company will pay after the maturity (more than one year).
Total equity is the aggregate of retained earnings and shareholder’s equity.
Shareholder equity – Refers to the amount that shareholder invests in the company.
Retained earnings – The amount that the company keeps from profit.
Comparing the manufacturing sector and service sector, we find that the D/E ratio of the manufacturing industry is high because of the higher amount of prior investment in machinery and other services.
Other Leverage Ratios:
Some other leverage ratios to calculate financial leverage are as follow:
- Debt to EBITDA Ratio
- Interest Coverage Ratio
- Debt to Capital Ratio
Most common ratio to calculate company leverage in corporate finance is Debt to Equity Ratio. However, one can also use the ratios given above to understand its leverage effect on a broader level.
The Risk Associated with Financial Leverage:
Financial leverage looks attractive, and of course, they can enhance the earning of a company, but they also bring many risks and losses with them.
Losses occur when the rate of interest rises, and the value of the asset declines to the level where it becomes hard to manage or control. They may also occur when interest payments for the asset start creating a burden on the purchaser.
The Volatility of Stock Price
A substantial swing in profit observes in case of increased amounts of leverages. The result of this swing directly affects the company’s stock price, which frequently rises and falls abruptly.
It hinders the accounting of stock options that the company employees own. This increase in stock price will deliver the message that shareholders of the company will get higher interest.
It observes that companies with high barriers on entry are more likely to fluctuate in comparison to the business which offers low restrictions on entry, profit and revenues.
This revenue fluctuation pushes a business or firm into bankruptcy because it fails to meet its increasing debt compulsions and finance its operating expenses.
This case of unpaid debts triggers the finance provider to file a claim of bankruptcy against the company in the bankruptcy court. The only way left in this case will be auctioning the assets to retrieve the company’s debt.
Reduced Access to More Debts
Before lending a loan to the companies, the financer checks every minute details related to the financial leverage level of the firm.
The higher debt-to-equity ratio of the company, higher is the risk involved in issuing additional funds. Because no financial provider will issue a loan to a company which is engulfed by the uncertainty of loan repayment.
However, suppose the finance lender agrees to give away a loan to these companies. In that case, he will charge a higher interest rate, to compensate for the higher risk factor associated with the firm.
Operating leverage is the ratio of variable costs to the fixed expenses incurred by a firm at a given time.
A company is tagged with a high operating leverage firm when its variable cost is lower than the fixed price. Such a company is sensitive to changes in the volume of sales. The market volatility also affects these firms EBIT and returns on capital invested.
Similarly, a low operating leverage firm tag is given to the firm whose variable expenses are more than fixed.
Capital-intensive firms include manufacturing firms; they have high operating leverage because they purchase many machines to carry out production. Fixed costs such as overhead on manufacturing plants, depreciation on machines and tools, maintenance cost, is a mandatory value which a company pays regardless of whether its products sell or not.
The leverage seems to be attractive sometimes, but it also brings loss along with it if not taken care of.
It is better to understand things before dealing with such issues. This guide will surely help you with financial leverages, its measurement and how it can define the quality of your company.