Question

What is meant by the term, 'leverage', and why is it important to managers? What are some examples of some companies or industries that would tend to be more highly leveraged? Which ones might be less leveraged? Why do you think this is the case?

Answer 1

Leverage is the strategy to use borrowed resources to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets, or the use of other people's resources in running the business. It is the relationship between the firm's fixed and variable costs. Using such resources entails a fixed cost to be paid for the use of these resources. Finance charges on debt, lease rent, fixed salaries are examples of such cost.

Leverage helps to increase the scale of business, thereby increasing productivity. Increased productivity leads to increased income, and which in turn increases the return on investment of a business. A higher ROI culminates in a higher Return on Equity ( ROE), if the equity multiplier is greater than 1. The equity multiplier exceeds 1 only when Total Assets / Equity exceeds 1. That would happen only when a part of the assets is financed by debt.

If all the assets of a business are financed by equity, ROE = ROI

If part of the assets is financed by debt, ROE > ROI, provided the rate of return exceeds the cost of debt.

Examples of industries with high leverage: Aviation, Utilities, Banking, Technology

Examples of industries with low leverage : Restaurants, Retail, Services like Accounting, Taxation etc

Answer 2

When a company invests to develop its asset base and create returns on risk capital, it uses borrowed capital as a funding source. Leverage is an investment technique that involves leveraging borrowed money—specifically, various financial instruments or borrowed capital—to boost an investment's potential return. The amount of debt a company utilises to finance assets is often referred to as leverage.

Example of Leverage

A $5 million investment from investors resulted in a $5 million equity in the company, which is the money the company may use to run. If the company borrows $20 million in debt financing, it now has $25 million to invest in business operations and greater opportunities to generate shareholder value.

For example, an automaker could take out a loan to construct a new factory. The new factory would allow the company to increase production while also increasing earnings.

Importance of Leverage

Businesses profit from leverage in the following ways:

• It is an important instrument for management to employ in making the best financing and investment decisions;

• It provides a variety of funding options through which the firm may attain its target earnings.

• Leverage is a key investment approach because it allows corporations to establish a limit on how far they can expand their operations. It can, for example, be used to suggest that a company's expansion be limited if the expected return on additional investment is less than the cost of debt.

The majority of the time, the effect of leverage on the homeowner is positive. Financial leverage, on the other hand, must meet two key criteria in order to be helpful. To avoid repossession, the borrower must first be able to make payments. Second, the leverage is determined by the underlying asset's worth. Leverage increases the potential profit on the property if the asset increases in value, but it diminishes the returns on investment if the asset decreases in value. If these two conditions are not met, leverage becomes unfavourable.

In the late 1980s, management of some corporations took on considerably more debt than they could repay to finance expansion and acquisitions, spurred on by investors and low interest rates. When they couldn't return their hazardous loans, many of these companies, including Orion Pictures, Live Entertainment, Carolco, New World Pictures, and Cannon Group, filed for bankruptcy. The majority of these corporations, many of which are from Hollywood, forgot that even if the projects they backed with the funding failed, they still had to return their loans. A corporation must employ reasonable estimates, smart management judgments, common sense, and an unbiased appraisal of the risks.

The issue with leverage is that most people are sentimentally hopeful about its ability to increase revenues without considering the potential obligations they will have to repay if the strategy fails. When new businesses open, they can either hit the ground running as the town's newest phenomenon, only to lose steam when a new competitor draws purchasers' attention away from them, or they can start slowly and create a reputation as more people become aware of their great service delivery. Borrowing, on the other hand, raises the business's fixed costs. It is critical to anticipate potential problems if you want borrowed finances to be effective.