Financial Leverage De-Mystified

Sometimes the language of finance makes it sound more complicated than it really is. Here we look at leverage from an individual perspective and then apply that understanding to corporate finance.

What Is Leverage?

Financial leverage simply means borrowing. It’s debt. When you use someone else’s money to finance your business operations or purchase assets, that’s leverage. So why would you want to use leverage?

Say you want to buy a rental house that costs $100,000. If you pay for it outright, you’re not using financial leverage and you’ve got $100,000 of your own money tied up in that investment, 100%.

Using leverage, that same $100,000 might represent a down payment on a small apartment building that cost $300,000. In this case, you’d take out a loan for $200,000. Now you’ve got control over $300,000 worth of assets, but you’ve only invested a third of that to do it. You’ve got three times the asset generating income – because that’s what assets do. They make you money!

When Leverage Works in Your Favor

Now, current economic conditions aside, say you hold your real estate for a few years and it increases in value by 15% over that time. You decide to sell. Here’s where debt leverage really pays off.

• If you didn’t use debt (your investments were not leveraged), your $100,000 property is now worth $115,000. You sell it for a profit of $15,000, which represents a 15% return on your investment of $100,000.
• Now, say you’re leveraged. Your $300,000 property has increased in value to $345,000. You sell it and profit by $45,000, a whopping 45% return on your $100,000 investment!

When Leverage Sucks

The above scenario looks great, no? Leverage is a great deal during boom times, but what if assets decrease in value? You can probably guess that leverage works in reverse when assets plummet in value. Instead of increasing by 15%, let’s say real estate values drop by that same percentage and you were compelled to sell.

Had you not used any leverage and your $100,000 rental house dropped to 85,000, you’d be out $15,000, or 15% on your initial investment.

If you’d leveraged your investment to buy the $300,000 apartment building, and it dropped to $250,000, you’d lose $45,000 on a sale. This represents a 45% loss on the initial $100,000 investment.

This is exactly what happened when millions of people took out huge mortgages with very small down payments. It happens with corporations too.

Corporate Finance: Bonds vs. Stock

What motivates a corporation to issues bonds instead of stock?

One reason a company might prefer to issue bonds is because of the tax ramifications. Whether they issue bonds or stock, the company needs to provide a return on investment for whomever buys the bonds or stock. The return on bonds is interest and the return on stock is price appreciation and dividends. Interest on bonds and other debt is tax deductible. Dividends on stock are not.

Also, when a company issues stock, ownership and power are distributed among a larger base of owners. Issuing bonds does not create new owners in a corporation, only new debtors. Gains in the value of the company’s assets belong only to the stockholders, while the bond holders receive only their interest as payment. It’s no different that the example of buying a rental house vs. an apartment building. Through the use of debt, the corporation controls a much larger asset base. If the asset proves profitable, more of the earnings go to the company.

Trading on Equity

Sometimes when companies choose to raise money by issue bonds instead of stock, it’s called ‘trading on equity’. The corporation uses debt to increase its earnings on common stock.

• A situation where trading on equity increases earnings: A company uses long term debt to purchase assets, and those assets produce enough income to cover the interest on the debt PLUS more. These excess earnings increase the earnings of the corporation’s common stockholders. (Of course if the new assets fail to earn more than the cost of the debt – the interest- then the earnings of the common stockholders will decrease.)

Understanding how corporations use debt financing is an important part of any financial analysis.

Using the Debt to Equity Ratio

The debt to equity ratio is an important metric to look at when you’re analyzing the financial health of a company. It’s a simple calculation: Liabilities/Stockholders’ Equity. Higher ratios are associated with a higher level of risk for the creditors. For the debt to equity ratio to be most valuable, compare a company’s ratio to its industry, as well as its own ratios from periods past.

If you have any questions about leverage, post them in the comments and we’ll get them answered!

Photo Credits: NCinDC, Flickr and PinkMoose, Flickr