Financial Leverage | Importance of Financial Leverage

Financial Leverage

The chief financial officer has among his missions the implementation of the financial policy. For this, he must respect the constraints of the company and the objectives of the shareholders. Financing choices raise the issue of leverage and maximum repayment capacity. Financial leverage refers to the respective weighting of equity and financial debt in the financing of the enterprise. This concept is therefore at the heart of the financial policy that the CFO must implement.

A financial leverage of 2 means that there are two Euros of financial debt (net debt) for one euro of equity (capital & reserves). Financial debt provides “leverage” by allowing the financing of assets for an amount greater than the contributions of shareholders. Debt financing is obviously necessary to complement the limited contribution capacity of shareholders. It also plays a key role in improving the return on equity and bringing it to the level desired by shareholders.

The Importance of Financial Leverage

The impact of the leverage effect is measured by the difference between the return on equity ratio and the economic profitability ratio. After the impact of corporation tax: 10% x (1 – 30%) = 7%. In the absence of indebtedness, return on equity would have been equal to 7%.

The capital investor usually has a higher return on equity than the economic return ratio. Leverage is then essential to bring the return on equity to the level required by these investors.

The Limits of Financial Leverage

The financial leverage obviously has an important limitation which is the repayment capacity of the company. It is recommended to limit the leverage effect in cyclical activities or subject to significant risks. For example, how does a winter sports resort that finances its entire infrastructure with debt manage to repay the years without snow?

In addition, when economic profitability falls below the cost of debt. Then the downward impact on the financial rate of return is also “multiplied” in proportion to the weight of the debt.

Repayment Capacity in Financial Leverage

In practice, the maximum indebtedness is determined from the projected cash flows calculated in the business plan. Moreover on a spreadsheet complementary to the financing plan. The reasoning is irrefutable: the maximum amount that can be borrowed is the maximum amount repayable. Through the cash flow generated by the business over a reference period.

Constraints in Repayment of Financial Leverage

Calculating the repayment capacity is not always sufficient to make the financing decision. Other constraints may appear i.e. constraints related to compliance with banking standards on debt ratios. For example: the financial autonomy ratio (equity / liabilities).

Constraints related to the nature of the assets to be financed. Whether for conventional loans (corporate financing) or asset financing (leasing, long-term leasing). The lender will analyze the pledge value of the financed property. Also may refuse to finance very specific equipment that does not find a buyer in case of unpaid. The leasing companies calculate the loan to value ratio over the entire duration of the financing. Then they ensure that the pledge value of the financed property is always greater than the outstanding amount of credit

Constraints related to the cash flow profile. Often, the company does not generate a positive cash flow (self-financing capacity) for the implementation of financing. She is, however, obliged to start repaying it. There are two possibilities:

• Negotiate a deferred principal repayment with the lender. The borrower, however, pays the interest. Such a deferral is not systematically accepted and is generally granted for a maximum of two years.
• Financing the first repayments through current account contributions from associates. Basically who ensure the connection between the first deadlines and the appearance of a positive self-financing capacity.

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Risks of Financial Leverage

While financial leverage can boost a company’s profits, it can also lead to excessive losses. Losses may occur when the asset’s interest expense payments overpower the creditor because the asset’s returns are insufficient. This can happen when the asset’s value drops or interest rates reach unmanageable levels.

• Volatility of stock price
• Bankruptcy
• Minimal Access to More Debts

Volatility of Stock Price

Big shifts in company earnings can occur as a result of increased financial leverage. As a result, the company’s stock price would fluctuate more often. And making accurate accounting of stock options held by company employees difficult. As stock prices rise, the company would be able to pay higher dividends to its shareholders.

Bankruptcy

Revenues and earnings are more likely to fluctuate in a business with low barriers to entry than in a business with high barriers to entry. The inability to meet rising debt obligations and pay operating expenses due to sales fluctuations might easily drive a company into bankruptcy. With unpaid debts remaining, creditors could bring a case in bankruptcy court. Just to have the business assets auctioned off to recover their debts.

Minimal Access to More Debts

When lending capital to businesses, lenders consider the firm’s degree of financial leverage. Lenders are less likely to advance additional funds to businesses with a high debt-to-equity ratio. Since because the probability of default is higher. If lenders agree to advance funds to a highly leveraged company. Then the lender may charge a higher interest rate to compensate for the increased risk of default.