It’s impossible not to encounter the term “financial leverage” as you go through the course of everyday business. After all, the term is considered among the many essential finance terms every entrepreneur needs to know.
As you might already know, the term refers to a type of debt financing. Whether you’re new to business or have already been operating for years, familiarizing yourself with the ins and outs of financial leverage will give you an advantage.
Here, we have rounded up everything you need to know about this type of debt financing. Get to know how it works, how it is used, its benefits, as well as its drawbacks by checking out our brief guide below.
What is Financial Leverage?
Although businesses vary in terms of their main activities, they all share a common feature: they need capital to maintain their operations.
From funding their office space, salaries, and wages to purchasing office equipment and supplies to much more, there are tons of costs associated with maintaining business operations.
Normally, businesses can finance their working capital out of their profits. However, this is not always the case.
Often, when a business is just starting, growing quite fast, or want to seize bigger opportunities, the required capital cannot match with the surplus generated from its operations.
When this happens, businesses often choose to borrow the funds they need. Financial leverage, in particular, is a type of financing strategy that involves borrowing of capital to increase a business’ assets, cash flows, and returns.
To simply put it, when a company borrows a certain sum of cash and then use that borrowed money to expand the firm’s asset base and generate more profit than the cost of the borrowed money, that’s an example of financial leverage.
How Does Financial Leverage Work?
Generally, financial leverage could take on three forms.
As explained by Corporate Finance Institute, “When purchasing assets, three options are available to the company for financing: using equity, debt, and leases. Apart from equity, the rest of the options incur fixed costs that are lower than the income that the company expects to earn from the asset. In this case, we assume that the company uses debt to finance asset acquisition.”
Benefits of Financial Leverage
There are many reasons why companies opt to leverage their finances. Perhaps, the most common is the promise of enhanced earnings.
By borrowing money, businesses can have the purchasing power to have more assets, thereby leading to more sales (ex: more machines = more products = more sales).
Another advantage associated with financial leverage is that it helps improve the overall credit rating of the business.
Overall, the continuous surge in business failure made lenders extremely tight in accepting applications – even from businesses that may be financially stable.
Once a company happens to secure funds through financial leverage and maintain a good record in terms of repayment, this will help the business build a good credit rating, which can be its ticket to better investment and borrowing deals in the future.
Downsides of Financial Leverage
Of course, similar to all other debt financing strategies, financial leverage comes with risks. In fact, it can result in disproportionate losses, and worse, bankruptcy.
Generally, if an entrepreneur uses leverage to make an investment, say expand his business, but ended up with no favorable returns (i.e. his business did not click, etc.), then he or she will face greater loss.
When this happens – when the returns from the asset are not sufficient – financial leverage becomes a one-way ticket to insolvency.
The Bottom Line
The world of finance is loaded with complex terminologies. For many entrepreneurs and investors, “financial leverage” is among those that are quite difficult to grasp.
If you’re looking for a way to boost your business or eyeing to seize bigger opportunities, familiarizing yourself with this type of debt financing is crucial to know whether it is the right path to take.
To have a better idea, talk to a financial advisor today!
