Both investors and companies employ leverage (borrowed capital) when attempting to generate greater returns on their assets. However, using leverage does not guarantee success, and possible excessive losses are more likely from highly leveraged positions.

Leverage is used as a funding source when investing to expand a firm's asset base and generate returns on risk capital; it is an investment strategy. Leverage can also refer to the amount of debt a firm uses to finance assets. If a firm is described as highly leveraged, the firm has more debt than equity.

For companies, two basic types of leverage can be used: operating leverage and financial leverage.

Key Takeaways

  • Companies take on debt, known as leverage, in order to fund operations and growth as part of their capital structure.
  • Debt is often favorable to issuing equity capital, but too much debt can increase the risk of default or even bankruptcy.
  • Operating leverage and financial leverage are two key metrics that investors should analyze to understand the relative amount of debt a firm has and if they can service it.

Operating Leverage

Operating leverage is the result of different combinations of fixed costs and variable costs. Specifically, the ratio of fixed and variable costs that a company uses determines the amount of operating leverage employed. A company with a greater ratio of fixed to variable costs is said to be using more operating leverage.

If a company's variable costs are higher than its fixed costs, the company is using less operating leverage. How a business makes sales is also a factor in how much leverage it employs. A firm with few sales and high margins is highly leveraged. On the other hand, a firm with a high volume of sales and lower margins are less leveraged.

Although interconnected because both involve borrowing, leverage and margin are different. While leverage is the taking on of debt, margin is debt or borrowed money a firm uses to invest in other financial instruments. For example, a margin account allows an investor to borrow money at a fixed interest rate to purchase securities, options, or futures contracts in the anticipation that there will be substantially high returns.

Financial Leverage

Financial leverage arises when a firm decides to finance the majority of its assets by taking on debt. Firms do this when they are unable to raise enough capital by issuing shares in the market to meet their business needs. If a firm needs capital, it will seek loans, lines of credit, and other financing options.

When a firm takes on debt, that debt becomes a liability on its books, and the company must pay interest on that debt. A company will only take on significant amounts of debt when it believes that return on assets (ROA) will be higher than the interest on the loan.

Outcomes

A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales. If a future sales forecast is slightly higher than the actual, this could lead to a huge discrepancy between actual and budgeted cash flow, which will have a significant effect on a firm's future operating ability.

The biggest risk that arises from high financial leverage occurs when a company's return on ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.