High leverage refers to the situation when a business or investment is financed to a large degree using borrowed money. High leveraging increases financial risk and the potential for gains and losses.
What is High Leveraging?
High leveraging, in financial terms, means utilizing a significant amount of borrowed funds relative to equity to finance the acquisition of assets or investments. The practice of leveraging allows businesses or investors to amplify their potential returns. However, it also multiplies the risk of losses if the investments do not perform as expected.
Calculation of Leverage
The degree of leverage can be quantified by the leverage ratio, which compares a company’s borrowed capital (debt) to its equity. The formula for the leverage ratio is:
A higher ratio indicates a higher degree of leverage.
Types of Leverage
Operating Leverage
Operating leverage is concerned with the cost structure of the company – how fixed costs and variable costs are used in its operations. Companies with high operating leverage can see substantial increases in operating income with a small increase in sales due to their higher proportion of fixed costs.
Financial Leverage
Financial leverage involves the use of debt to finance the purchase of assets. Increased financial leverage can significantly alter a company’s financial performance due to the fixed cost of debt repayments.
Combined Leverage
Combined leverage, or total leverage, is the collective impact of both operating leverage and financial leverage on a company’s earnings before interest and taxes (EBIT).
Implications of High Leveraging
Increased Financial Risk
Highly leveraged companies are more vulnerable to downturns in the market. The obligation to make interest payments regardless of revenue impacts profits during economic slowdowns.
Potential for Higher Returns
If investments financed by debt perform well, the returns on equity can be significantly higher due to the amplified effect of using borrowed funds.
Possibility of Bankruptcy
Excessive leverage can lead to insolvency if the debt obligations cannot be met, leading to potential bankruptcy.
Historical Context
The concept of leveraging dates back centuries, but significant examples can be observed during economic events like the 2008 Financial Crisis. Over-leveraging by financial institutions and borrowers was a key factor in triggering this economic downturn.
Examples of High Leveraging
Real Estate Investment: Property developers often use high leverage by taking large loans to finance development projects. If property prices rise, they can earn substantial profits.
Corporate Buyouts: Leveraged buyouts (LBOs) are a common practice where a company is acquired using a significant amount of borrowed funds, with the acquired company’s assets often serving as collateral.
Comparisons
High Leverage vs. Low Leverage
- High Leverage: Greater potential for returns and higher risk.
- Low Leverage: Lower risk of insolvency but potentially lower returns.
Related Terms
- Debt-to-Equity Ratio: A measure of a company’s financial leverage calculated by dividing its total liabilities by its stockholders’ equity.
- Debt Financing: Raising capital through borrowing.
- Equity Financing: Raising capital through the sale of shares.
FAQs
Is high leverage always bad?
No, high leverage is not inherently bad. It depends on the context and how well the borrowed funds are managed. If leveraged investments succeed, they can provide significant returns. However, mismanagement and economic downturns can lead to severe financial difficulties.
What industries commonly use high leverage?
Industries such as real estate, private equity, and banking commonly use high leverage due to the capital-intensive nature of their operations.
How can a company reduce leverage?
A company can reduce leverage by paying off debt, improving profitability, and raising equity capital.
References
- Modigliani, Franco and Miller, Merton H. “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review.
- Ross, Stephen A., et al. “Corporate Finance,” McGraw-Hill Education.
Summary
High leveraging is a double-edged sword in the world of business and investment. While it can amplify returns when managed correctly, it also increases financial risk and the possibility of insolvency. Understanding the implications and managing the risks associated with high leverage is crucial for businesses and investors aiming to optimize their financial performance.
