Using Financial Leverage to Grow a Business
In economics, financial leverage is any method by which the indebtedness of a creditor is increased, with the hope that the net gain to creditor equity by the sale of an indebted asset will more than offset the increased indebtedness. Leverage in other words, is the ability to obtain finance at a lower interest rate or in exchange for service of less capital. Thus leverage in finance can mean two things. First, the increase in financial leverage is necessary in order to raise money for business purposes such as buying inventory and so on. Second, the increase in financial leverage also allows the possibility of financial loss through an event of default by the creditor.
The debt-to-equity ratio, debt to equity, is another important measure of financial leverage. This is the ratio of net worth (the value of the firm’s tangible assets divided by its liabilities) to its equity. When the figure is high, this indicates that the firm’s value is increasing. A high debt-to-equity ratio also indicates an over-reliance on external funding sources. External financing sources include government loans, venture capital, and credit facilities from banks and other financial institutions. As these sources are only available for certain times, the tendency is for the firms holding them to use up the existing supply before they can complete repayment of their loan, which leads to a rise in the debt-to-equity ratio.
Let us take the example of a new factory that has been built and is going to be operated by its own employees. The owner intends to keep the profits from this new factory. But due to poor financial leverage, he cannot get more money to fund the operation. Instead of gaining more profits, his workers suffer. His profits remain idle.
To improve financial leverage, an owner can sell some of his existing shares to his workers so that he can pay for the operation cost. This will result in increased gross profit. However, there will be two negative implications of selling such shares. One negative impact is that it will reduce the net income of the firm. Secondly, the owners will have to provideividation or dividend payment to his stockholders.
Net profit margin, net income divided by total number of shares outstanding, tells the story of profit and losses at a particular period of time. The higher the percentage difference between profits and losses, the greater is the net income leverage. The profit and loss ratio tell us how much profit a firm has made over a given period of time. Positive ratios (positive earnings per share) indicate healthy profits; negative ratios (negative earnings per share) indicate unhealthy profits.
The earnings per share helps investors to calculate the risk of holding a particular company’s shares as they have been weighed in relation to the market value of that company’s stock. The ratio gives information about the health or the otherwise of the firm.
Financial leverage ratios are used to calculate the net present value of future payments of principal and interest on debt or equity. The present value of the financial leverage ratio is defined as the net present value of the sum of all future cash payments (including interest and capital gains) less the current value of all current cash payments. This calculation tells how much debt can be financed by the firm. In order to reach a certain level of financial leverage, it may be necessary to raise more money from investors than the firm has in hand.
Other types of financial leverage are interest rate, coupon rate, foreign currency, mortgage rates, and credit spreads. All these forms of financial debt are related to the prices of goods and services that are set locally and globally. A particular country’s currency can appreciate or depreciate depending on the performance of the stock and bond markets of that country. The debt of a firm refers to its common equity. The debt of a corporation refers to its owner’s equity.
Financial leverage can be used for business investment purposes. It can be leveraged to buy shares or other kinds of assets that can be used to increase the value of the firm. The value of such assets is dependent on the performance of the underlying enterprise. To use financial leverage wisely, a firm must keep track of its equity and debt balances at all times. To help determine the extent to which they need to make use of leverage, business owners should consult an expert on the topic.