Impact of financial leverage

Financial leverage is the degree at which organizations or companies uses fixed income including preferred equity, securities and debts in their capital structure. With high financial leverage, high interest payments are also generated. This means that the earnings per share at the bottom line are negatively impacted by interest payments. On the other hand, high interest payments lead to high financial leverage and EPS will be driven lower.

Therefore, a corporate organization and its management have a duty to employ a thorough and a highly prudent process to create a target for its capital structure. This refers to the way an organization finances its growth and operations by use of various sources of finance.

Impact of financial leverage on a company

Taking on debt as an organization often brings about a high level of risk. This is attributed to the fact that finances and income must be used to pay back debts even if cash flows go down. From a company perspective, financial leverage can easily impact it negatively or even positively on its return on equity as a result of heightened risk level.

Effect on return on equity

Return on equity is the return on the equity of shareholders of a given organization, more specifically, common stock owners. This is because it measures the level of efficiency of a firm’s profit generation. Return on equity tells how good an organization uses investment funds to grow its earnings.

At an ideal financial leverage level, the return on equity of an organization increases because the use leverage increases the volatility of stock. This further increases its level risk and increases returns. However, if an organization is over leveraged financially, a decrease on return on equity would occur. Financial over leveraging means huge debts due to high borrowing of finances and at a lower interest rate while spending more money on high risk investment.

It is imperative to note that is investment risk is relatively higher than the desired or the expected return, the value of a company’s equity could easily go down as many stockholders tend to believe that it is too risky.

Impact of financial leverage, risks and misconceptions

Multiple losses are one of the risks and impacts of financial leverage. Its effect on solvency forces a company to borrow a lot of money. This can lead to multiple losses and in the end, bankruptcy. Bankruptcy is quite common when higher liquidity occurs.

There is a misconception that higher losses also occur among individuals who borrow money for personal use. This is because it leads to higher consumption levels and more specifically on credit cards. However, in finance, borrowing money is a general practice but for those who want to buy assets with a higher return than the interest level of the money borrowed. Therefore, instead of spending cash that an organization doesn’t have, it in the end creates value but in the case of personal use, there is no value and no leveraging being created.

On a positive note, financial leverage adds value to an organization and its activities. If an organization borrows cash to modernize, enhance its brand visibility nationally and internally and grow its product line, this will often offset risks from financial leverage. This means that if value is expected due to financial leverage, the additional risk will not have a negative impact on the organization and its investments.

Financial leverage bottom line

The bottom line is that financial leverage is mainly used by organizations primarily to enhance its earnings per share and return on equity. Even so with these benefits, there is increased variability on earnings and possibility of a financial distress, perhaps bankruptcy.

The management of an organization with these in mind should therefore focus taking into account business risk of an organization, its tax position and its financial flexibility based on its capital structure and managerial aggressiveness level when deciding on optimal capital structure.

It is imperative to note that ensure that while employing financial leverage to increase performance of the company, it should be done to ensure flexibility in raising future capital because the market environment is characterized with a lot of changes.

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Sources

http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/financial-leverage.asp

https://www.boundless.com/finance/textbooks/boundless-finance-textbook/capital-structure-13/thinking-about-financial-leverage-106/impacts-of-financial-leverage-452-3856/

http://www.investopedia.com/articles/investing/111813/optimal-use-financial-leverage-corporate-capital-structure.asp