Financial Leverage and Risk
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The use of debt to fund investment in a company’s assets is called financial leverage. This critical concept should be understood because of its effect on equity holders’ return on investment (ROI) and the risk it introduces for both lenders and investors.
As mentioned above, creditors, while having legal claims against the assets of a company, do not share in profits or losses. This benefits equity investors because they do not suffer dilution of ownership shares when debt is added or share profits with creditors during good times. This has a magnifying effect on investor ROI. This favorable leverage effect, however, works both ways. During downturns in your business or the economy, leverage magnifies the losses investors incur.
Because of this leverage, the use of debt financing has introduced volatility, and therefore risk, that investors must face. Because creditors rely on a company’s solvency to provide for debt service and ultimate repayment, creditors also face increased risk from the added leverage.
Remember that just as creditors do not share in profits, they also do not share in losses. However, interest and principal are fixed costs to the company that must be paid, regardless of profitability, to avoid default and bankruptcy.
Before deciding on how much debt to add to the balance sheet, it is essential to forecast different financial scenarios, including a business downturn or a worst-case scenario. Then, it can be determined if the leverage under consideration will place the company at risk of insolvency.
Matching Debt to Assets
While excessive debt loads can often be identified with ratio and trend analysis, applying the proper type of debt to its intended use is also essential.
One mistake often made is mismatching the debt term with the intended use of the borrowed funds. Simply put, long-term assets should be funded by long-term debt. Suppose short-term debt with high interest and short repayment terms is used to finance capital equipment, for example, with a long lead time to achieve production. In that case, cash flows generated by that long-term asset will not be available soon enough to repay the debt, and that burden will be placed on other operations.
Such capital equipment is better financed with long-term loans or capital leases that better match the payout period with the project’s payback period. Similarly, short-term funding needs are better suited to short-term debt, such as trade payables, credit lines, or even, in some cases, credit cards with monthly payoffs. Using up long-term credit sources on short-term assets can result in an inability to obtain debt funding for long-term projects when needed. Again, opportunity costs need to be considered when using finite funding sources.