What is financial leverage and why do companies use it?



What is financial leverage and why do companies use it?

 Financial Leverage also referred to as trading on equity is a strategy used by companies to fund the assets of the company with debt instead of owner's equity. However, figuring out if taking leverage is good for your shareholders is a bit complex. Companies love to take leverage to improve the returns on equity. For better understanding let's take an example of 3 companies A, B, and C. Let us assume that the tax rate is 30%.

 Following table portrays the equity and 10% debt for the 3 companies:

If you watch carefully, company A has no debt, company B has 50%debt and 50% equity whereas company C has 66% debt and 33% debt. Now let's take a look at each of the company's shareholders position if all the companies:

1. Made a profit of $20,000: The following table portrays the returns the shareholders made on their investment.









It can be clearly observed that in the case of profits the higher the debt, the better is the return for the shareholders. The reason behind better returns is the tax-deductible nature of the interest on the debt. The lower tax is helping increase the returns for the shareholders. But we need to keep in mind that higher debt seems favorable only when the company is making profits. Since debt is a fixed cost and needs to be paid irrespective of profit or loss incurred, the risk of the company increases with higher debt.

2. Incurred a loss of $10,000: The following table portrays the returns the shareholders made on their investment.






From the above table, it can be seen that debt plays a very negative role when there are losses incurred in the company. The higher the debt, the more negative are the returns for the shareholders. This is because debt interest is a fixed cost. 

 This strategy to make use of debt to take tax advantage as well as to increase the returns for shareholders is called financial leverage. But this strategy fails if there are losses in the company. Therefore, if you are about to start a new company, you should aim to use your own money instead of borrowing through debt at steep rates.

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 Thanks for reading!
Please comment on any financial query you had like me to address. I will try to post something worthwhile. 

Coming up Next: What profession is pursued by the 10 richest people in the world?

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