Optimal Use of Financial Leverage in a Corporate Capital Structure

Incorporating financial leverage into a company’s capital structure influences the income statement. Additional debt affects both the top-line revenue and the bottom-line net income. Interest payments on debt must be reported as an expense, reducing the net income. The point and result of financial leverage is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out. When one refers to a company, property, or investment as “highly leveraged,” it means that the item has more debt than equity.

Financial Leverage vs. Margin

Financial leverage is the extent to which fixed-income securities and preferred stock are used in a company’s capital payroll structure. Financial leverage has value due to the interest tax shield that is afforded by the U.S. corporate income tax law. The use of financial leverage also has value when the assets that are purchased with the debt capital earn more than the cost of the debt that was used to finance them. To gauge the impact of financial leverage on a company’s profitability, analysts use the return on equity (ROE). ROE increases as financial leverage rises, provided the cost of borrowing is less than the return from investments. However, if the cost of debt exceeds the return, it can negatively impact profitability.

• A company with a high debt-to-EBITDA carries a high degree of debt compared to what the company makes.
• Generally, a ratio below one is preferable, but what’s considered favorable can vary depending on specific circumstances and investor risk tolerance.
• To gauge the impact of financial leverage on a company’s profitability, analysts use the return on equity (ROE).
• Yet, the funds obtained through leverage may enhance overall sales or revenue if used for profitable investments or expansion.
• Perhaps the best way to illustrate the positive impact of financial leverage on a company’s financial performance is by providing a simple example.
• Applying financial leverage strategically can greatly impact a company’s long-term financial health and market position.

Trade-Off Theory

First, successful use of financial leverage requires a firm to from the standpoint of management, companies that are run by aggressive leaders tend to use more financial leverage. In this respect, their purpose for using financial leverage is not only to increase the performance of the company but also to help ensure their control of the company. Many quantitative and qualitative factors need to be taken into account when establishing a company’s capital structure. The funds-from-operations-to-total-debt ratio and the free-operating-cash-flow-to-total-debt ratio are also important risk metrics that are used by corporate management.

Understanding Financial Leverage

Financial leverage can significantly increase the return on equity, enhancing an investor’s profit from capital invested. By borrowing funds, investors can increase their buying power, enabling larger investments than would be possible with available capital alone. If the investment’s value increases, this can lead to disproportionate gains. ABC Bookkeeping for Painters Ltd. expanded its business unit by investing $ out of which $50000 was acquired through debts.

A lower D/E ratio typically signifies a financially stable business that has been less reliant on debt to fuel growth. Financial experts frequently compare the D/E ratio against industry averages to assess risk levels. As a result, even a slight fluctuation in sales can substantially impact its operating income. Companies continuously aim to find the ideal balance where operating leverage maximizes profitability without unduly increasing their financial risk. Utilization of leverage substantially impacts a company’s financial reporting, specifically on metrics such as earnings per share, balance sheet, and income statement. These impacts can be seen in the ability to increase shareholder value and raise a company’s financial risk profile.

Investors who are not comfortable using leverage directly have a variety of ways to access leverage indirectly. They can invest in companies that use leverage in the ordinary course of their business to finance or expand operations—without increasing their outlay. For example, since 2016, Apple (AAPL) has issued $4.7 billion of Green Bonds. By using debt funding, Apple could expand low-carbon manufacturing and create recycling opportunities while using carbon-free aluminum. An issue with using EBITDA is that it isn’t an accurate reflection of earnings. It is a non-GAAP measure some companies use to create the appearance of higher profitability.

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