Avoiding the Leverage Trap

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Leverage, as a corporate word, refers to debt or to the borrowing of funds to finance the acquisition of inventory, equipment and other company assets. Business possessors can use either debt or equity to finance or buy the company’s possessions. Using liability, or leverage, increases the company’s possibility of bankruptcy. It also increases the business’s returns; specifically its return on equity.

With debt funding, nonetheless, whether the interest charges are from a loan or line of credit, the interest expenses are tax deductible. In addition, by making well-timed payments, a business will inaugurate a positive payment history and business credit rating. Stakeholders in a company prefer the business to use debt financing, but to a degree. Beyond a certain point, financers get nervous about too much leverage, as it drives up the business’s default risk.

Types of Leverage

 

1.    Operating Leverage

Break even analysis displays that there are fundamentally two types of costs in a corporation’s cost structure i.e. fixed costs and variable costs. Operating leverage states the ratio of fixed costs that an enterprise has. Basically, operating leverage is the proportion of fixed costs to variable costs. If a corporate firm has a lot of fixed costs as compared to variable costs, then the company is said to have high operating leverage.

2.    Financial Leverage

Financial leverage refers to the amount of debt in the capital structure of the business firm. In layman’s terms, financial leverage refers to the right-hand side of the balance sheet. Operating leverage refers to the left-hand side of the balance sheet – the plant and equipment side. Operating leverage determines the mix of fixed assets or plant and equipment used by the business firm. Financial leverage refers to how the business will pay for it and how the operation will be financed using bookkeeping strategies. One of the financial ratios used in calculating the volume of financial leverage we have in a business firm is the debt/equity ratio. The debt/equity ratio shows the proportion of debt in a business firm to equity.

3.    Combined or Total Leverage

Combined or total leverage is the total amount of risk facing a business firm. So we can also say that it is the total amount of leverage that we can use to magnify the returns from our enterprise. Operating leverage magnifies the returns from our plant and equipment or fixed assets. Financial leverage magnifies the returns from our debt financing. Combined leverage is the total of these two types of leverage or the total magnification of returns. This is looking at leverage from a balanced bookkeeping sheet viewpoint.

Risk Factors Associated with Leverage

1.  Investment Risk: In leveraging, you must invest the incomes of borrowed money. Leveraging does not avert you from justly making a bad investment decision.

2.  Magnification of losses:  If you use leverage to trade or purchase larger than you otherwise could, this will magnify your losses.  Be smart with your leverage. 

3.  Interest Rate Risk: There are a number of factors that affect your total return such as tax, investment return, and the cost of the loan. The key to efficacious leveraging is to have your after-tax investment return exceed your after-tax cost of interest.

4.  Cash Flow Risk: Increasing interest rates hve a ripple effect on your cash flow. If you are going to leverage, you must sustain the interest payments on the loan.

5.  Tax Risk: Keep in mind that success in leveraging requires that your after-tax returns must exceed your after-tax cost on the interest. Variations in tax rules could potentially hurt your leveraging program.

6.  Emotional Risk: Fear and greed can wreak havoc on any investment plan. It is even more imperative to keep a level head and direct resolutions using logic instead of emotions.

Conclusion

The bottom line is leveraging is a tremendous tool to build wealth. Before you jump in with both feet, take the time to understand the risks. Consult your financial adviser to see if leveraging, along with well-planned bookkeeping, makes sense for you.

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