Financial leverage means use of debt or borrowed capital to finance business, acquire additional assets or to increase profit. Financing a business depends on the capital structure of the company. Capital structure means the mixture of debt and equity financing to the business.
Equity financing does not create any obligations on the company. However, debt financing obligates the company to pay interest and principal amount as per the agreement, usually a periodical fixed amount.
When a company is referred as “highly leveraged”, it means that business is using more debt than equity. The greater the amount of debt, the greater the financial leverage.
You can read company’s balance sheet to understand how the company has financed it’s assets.
How financial leverage affect company earnings
Debt financing can help a company when business does well. However, they may suffer downside in case of economic downturn or when the company does poorly.
If the company earns more than the fixed obligations of debt, after paying to lenders they may distribute the earnings to owners or shareholders. However, it’s not mandatory for the company to pay dividends to shareholders. The company can keep the entire net earning for growth, acquisition or expansion.
In case of economic downturn, company may lose its earnings. The fixed nature of debt obligations affects the company’s earnings based on the capital structure adopted to finance the business. If the company earns less than these fixed obligations of debt, there are greater chance of default in repaying debt obligations which may result in bankruptcy.
Interest is a fixed obligation which must be paid no matter how low your earnings are. The greater the use of debt visa-a-visa equity, the greater the risk associated with earnings.This means, the greater the degree of financial leverage, the greater the financial risk.
Investors are always careful about companies which has significant financial leverage and high volatility operating earnings. Therefore, the greater the use of debt financing, the greater the risk.
How a company can reduce its debt burden
To reduce the debt burden, company must obtain money to pay interest or repay debts. Here are three alternative company can adopt;
- Sell company’s assets to pay debt,
- Take less costly debts or convert debt to equity,
- Issue more shares of stock to fund business.
A company which has difficulty in making payments to its lenders or creditors is in financial distress. If it continues, then company may lead to bankruptcy. Value investors always prefer less financial leverage companies to invest in case of recession or economic downturn