Question

What factors would cause a difference in the use of financial leverage for a utility company and an automobile company? Also, please discuss the limitations of financial leverage.

Answer 1

Use of financial leverage will differ for a utility company from that of an automobile company due to a number of reasons. First of all the level of capital intensity will be different for a utility company when compared to an automobile company. Utility companies like electricity companies or gas refining companies are highly capital intensive and hence requires use of more debt. This will lead to higher use of leverage in utility companies when compared to automobile companies. Secondly the gestation period for utility companies will be higher this will mean that it cannot be financed mainly through equity. Hence debt will be a major component. Thirdly the nature of business also causes the use of financial leverage to vary. Once the gestation period is over the business of a utility company becomes stable and hence the income generation for a utility company also stabilizes. The stability of utility companies largely remains unaffected by the changes in economic conditions and thus they have the capacity of carrying large amounts of debt. The business model of an automobile company is vulnerable to the economic conditions and hence it does not make sense for them to carry large amount of debt in their books.

The limitations of financial leverage start with the fact that financial leverage is a double-edged sword. By this I mean that financial leverage can be successful only when the rate of earnings is more than the fixed rate of interest. Secondly it becomes troublesome in scenarios in which there is no stability of earnings. Thirdly financial leverage is associated with increased risk and rate of interest. Incremental level of leverage can only be obtained at higher rates of interests and this increases the risk exposure of the companies taking incremental debt.