Leverage is the use of debt financing in the capital structure of a company. It means the use of borrowed money instead of using equity for funding the company projects. It is also commonly referred to as the ratio of debt to equity.
Leveraged finance lowers the cost of capital. It also increases the internal rate of return of a company. Thus, companies look to increase the use of leveraged finance whenever possible.
There are several uses of leveraged finance, debt refinancing, mergers and acquisitions, leveraged buyouts, etc. Each of the specific use of leveraged finance comes with its pros and cons.
What is Leverage in Finance?
Leverage in finance means using borrowed capital instead of equity to invest in projects. The more capital a company borrows the higher leveraged it becomes.
Leverage also refers to the debt-to-equity ratio of a company. It is simply the percentage of borrowed money and equity out of the total capital employed.
For large corporations, leveraged finance also refers to syndicate loans. These loans are specifically designed to use the borrowed money to fund large investments such as mergers and acquisitions, leveraged buyouts (LBOs), and debt refinancing.
How Does Leveraged Finance Work?
Companies have two sources of finance mainly; equity and debt. Most companies begin with a large proportion of equity financing. The proportion of debt financing increases gradually in the capital structure of the company.
When a company borrows money, it increases the leverage. The main attraction for leveraged finance is the reduced cost of capital. Debt financing reduces the cost of capital due to lower risk. The interest portion of the debt is also tax-deductible. Hence, debt borrowing brings the cost of capital down.
Leverage also amplifies the risks. A higher leverage ratio means the company is at greater risk of default. It means the cost of debt at a higher leverage ratio will become expensive. It will eventually put pressure on the company. A failure can lead to severe consequences such as bankruptcy.
Important uses of Leveraged Finance
Leveraged finance can have several uses. Most companies use borrowed money for positive NPV projects to increase the internal rate of return of the company. Companies can use the borrowed money for project-specific requirements as well.
For large companies, it can also have specific uses.
- Mergers and Acquisitions
- Debt Refinancing
- Management buyouts and Leveraged Buyouts
- Equipment financing and Leases
Special Considerations with Leveraged Finance
Leverage offers a lower cost of capital and increases the internal rate of return of a company. However, it also amplifies the risks for the company with excessive use of borrowed money. A highly leveraged company refers to having a greater proportion of debt than equity.
Higher leverage can bring additional risks such as a change in the company’s liquidity level, change in interest rate, fluctuations in cash flow, etc.
Analysts must carefully interpret the balance sheet of a leveraged company. Debt figures are recorded at book values in the balance sheet. However, analysts can use some key measures such as the Debt/Equity ratio, Return on Capital Employed (ROCE), and Return on Equity (ROE).
There is no set rule for the safe leverage level of a company. For instance, a large company with an established history and large assets can afford as much as 90% of the leveraged financing. Contrarily, a growing company with small assets could enter the danger zone if its leverage ratio increases by 60%.
Suppose a company starts operations with $ 20 million. The capital is all equity-funded by its shareholders. It borrows more money to fund an expansion project. It received a bank loan of $ 30 million from a commercial bank.
The total capital employed by the company is now $ 50 million. Its leverage ratio now stands at 60% (30/50*100%). It means the company’s 60% capital is leveraged.
Advantages of Leveraged Finance
Leveraged financing brings several benefits to a company.
- It improves the cash flow and liquidity of a company initially.
- The cost of capital reduces with the use of debt financing.
- Companies can use it for specific large projects such as mergers, acquisitions, and debt refinancing.
- It improves the internal rate of return of the company.
Disadvantages of Leveraged Finance
Leveraged finance can bring some risks and disadvantages for a company as well.
- A higher leverage ratio means the cost of capital increases significantly due to higher risks of default.
- A company may face liquidity problems due to large interest payments.
- It increases the volatility of a company’s cash flow and profits.
- It amplifies the risks of default for the company.
Leveraged financing offers great flexibility and value to a company in several ways. It brings the total cost of capital down and helps a company fund expansion projects. However, it is also risky and may backfire for the company if it does not manage the leveraged finances well.