Financial leverage

Definition

Financial leverage is the use of borrowed funds to increase the potential return on investment. By using debt to finance assets, companies can amplify their earnings, but this also introduces additional risk, particularly if the return on investment does not exceed the cost of debt. It plays a crucial role in the financial due diligence process, as assessing a company's leverage helps investors evaluate its financial health and risk profile.

5 Must Know Facts For Your Next Test

1. Higher financial leverage can lead to higher returns on equity when the company's earnings exceed the cost of debt, but it can also result in greater losses when earnings fall short.
2. During financial due diligence, investors analyze a target company's financial leverage to assess its ability to meet debt obligations and evaluate potential risks.
3. A company with excessive financial leverage may face liquidity issues during economic downturns, making it critical for investors to understand leverage levels before making decisions.
4. Investors often compare financial leverage among similar companies in the same industry to identify potential outliers and assess relative risk.
5. Sustainable financial leverage should align with a company's overall business strategy and market conditions, ensuring it does not jeopardize long-term stability.

Review Questions

• How does financial leverage affect a company's risk profile during the financial due diligence process?
  • Financial leverage significantly impacts a company's risk profile, as higher levels of debt increase the potential for both returns and losses. During financial due diligence, analysts assess leverage by examining ratios like debt-to-equity, which helps determine how well a company can manage its obligations. An elevated level of financial leverage can indicate higher risk, especially in volatile markets or economic downturns, where cash flows may not suffice to cover interest payments.
• Evaluate the importance of understanding a company's cost of capital in relation to its financial leverage during due diligence.
  • Understanding a company's cost of capital is essential during due diligence because it serves as a benchmark for evaluating whether the returns generated from investments will exceed the costs incurred from debt financing. Financial leverage can distort this balance; if a company's cost of debt is higher than its returns on leveraged investments, it risks reducing shareholder value. This evaluation allows investors to make informed decisions about the appropriateness of the target's capital structure and overall viability.
• Assess how an investor might balance potential returns against risks associated with high financial leverage when evaluating an investment opportunity.
  • An investor must carefully weigh potential returns against the inherent risks of high financial leverage by analyzing various factors such as market conditions, industry trends, and the target company's historical performance. They might conduct sensitivity analyses to forecast different scenarios based on varying levels of earnings and interest rates, helping gauge how robust the investment could be under adverse conditions. Ultimately, this assessment guides investors in deciding whether the potential upside justifies the risks involved in leveraging their capital.

Related terms

Debt-to-Equity Ratio: A financial metric that compares a company's total liabilities to its shareholder equity, indicating the relative proportion of debt and equity used to finance assets.

Cost of Capital: The return rate that a company must earn on its investment projects to maintain its market value and attract funds, factoring in the costs of debt and equity.

Risk Management: The process of identifying, assessing, and controlling threats to an organization's capital and earnings, including risks associated with high levels of financial leverage.