Impact of Financial Leverage
The impact of financial leverage on a company can be either positive or negative. Financial leverage refers to the degree of use of fixed-income securities by a company. This includes preferred equity and debt. High financial leverage implies that a company has high interest to pay.
As such, high financial leverage has a negative effect on the earnings per every share of the company. Taking debts increases risk for a company because income will be used to pay the debt back even when cash flows or earnings go down. This implies that taking debt impacts on the return on equity of the company negatively due to the heightened risk level.
In this case, return on equity refers to the rate of return on the equity of the shareholders of the common stock of the company owners. This measures the efficiency of a company in generating profit using the unit of the equity of the shareholders. Return on equity is used in determining how a company uses funds set aside for investment in generating increased earnings.
When a company has financial leverage at an ideal level, return on equity is increased when it uses leverage to increase stock volatility and thus, an increase in risk level which then increases returns is realized.
On the other hand, return on equity is decreased when a firm is over-leveraged financially. A company is over-leveraged financially when it borrows more at lower interest rates and then it invests the funds in high risk ventures. This can decrease the value of the equity of the company if the risk associated with the investment is more than the expected returns.
Another impact of financial leverage is that it can result in multiple losses. This is because financial leverage affects solvency. If a firm borrows a lot of funds it is likely to face bankruptcy in the time of business downturn. On the other hand, a company that is less-levered can avoid bankruptcy because it has higher liquidity.
On the positive side, financial leveraging can have positive impact on a company. For instance, if a firm borrows money and then uses it to modernize, expand internationally or add the product line, the added diversification can offset the risk associated with financial leveraging.
This is because if there is value added from using the financial leverage, the risk will most likely not affect the firm and its investment negatively. Thus, borrowing money to purchase assets is a good thing if high returns are expected from the move than the interest of the acquired debt.
Additionally, companies with high levels of financial leverage are more accountable on how they spend their funds. This is because in some cases they have to be accountable to creditors. Sometimes, they may be required to fill agreements and restrictions on capital use and the intended investments.
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Sources
http://www.streetdirectory.com/travel_guide/162419/finance/the_effects_of_financial_leverage.html
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.svtuition.org/2011/03/leverage-effect-on-roe.html
http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/financial-leverage.asp