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Impacts of Financial Leverage
Taking on debt, as an individual or a company, will always bring about a heightened level of risk due to the fact that income must be used to pay back the debt even if earnings or cash flows go down. From a company's perspective, the use of financial leverage can positively - or sometimes negatively - impact its return on equity as a consequence of the increased level of risk.
Impact on Return on Equity
Return on equity is the rate of return on the shareholders' equity of a company's common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity. Return on equity shows how well a company uses investment funds to generate earnings growth. It can be calculated using the following equation:
Return On Equity
The equation used to calculate return on equity.
At an ideal level of financial leverage, a company's return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns. However, if a company is financially over-leveraged a decrease in return on equity could occur. Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments. If the risk of the investment outweighs the expected return, the value of a company's equity could decrease as stockholders believe it to be too risky.
Leverage, Risk, and Misconceptions
The most obvious risk of leverage is that it multiplies losses. Due to financial leverage's effect on solvency, a company that borrows too much money might face bankruptcy during a business downturn, while a less-levered company may avoid bankruptcy due to higher liquidity. There is a popular prejudice against leverage rooted in the observation of people who borrow a lot of money for personal consumption - for example, heavy use of credit cards. However, in finance the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. Instead of spending money it doesn't have, a company actually creates value. On the other hand, when debt is taken on for personal use there is no value being created, i.e., no leveraging.
There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage. While involuntary leverage is certainly not a good thing, it is typically caused by eroding equity value as opposed to the addition of more debt. Therefore, it is typically a symptom of the problem, not the cause.
When evaluating the riskiness of leverage it is also important to factor in the value of the company itself and its activities. If a company borrows money to modernize, add to its product line, or expand internationally, the additional diversification will likely offset the additional risk from leverage. The upshot is, if value is expected to be added from the use of financial leverage, the added risk should not have a negative effect on a company or its investments.
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