Financial Leverage - definition & overview

Financial leverage, a crucial concept in the world of small businesses, is a strategy that involves using borrowed funds to increase the potential return on investment. In essence, it is a double-edged sword that can significantly amplify both profits and losses. This article will delve into the depths of financial leverage, elucidating its various facets, implications, and applications in the context of Australian small businesses.

As an entrepreneur or business owner, understanding the concept of financial leverage is critical to making informed financial decisions. It can be a powerful tool when used judiciously, but it can also lead to financial ruin if not managed properly. This detailed glossary entry will provide you with a comprehensive understanding of financial leverage, empowering you to utilise this financial strategy to its fullest potential.

Definition of Financial Leverage

Financial leverage, also known as trading on equity, refers to the use of debt to acquire additional assets. In the context of a small business, this could mean borrowing money to expand operations, purchase new equipment, or invest in research and development. The goal is to generate a higher return on the borrowed funds than the interest paid on the debt.

This strategy is based on the premise that the cost of debt is lower than the return on investment. When this holds true, the excess return accrues to the equity holders, thereby increasing the return on equity. However, if the return on investment is less than the cost of debt, the equity holders bear the loss.

Degree of Financial Leverage

The degree of financial leverage (DFL) is a measure of how much a company relies on debt to finance its operations. It is calculated by dividing the percentage change in earnings per share (EPS) by the percentage change in earnings before interest and taxes (EBIT). A higher DFL indicates a higher level of debt and, consequently, a higher level of financial risk.

For small businesses, a high DFL can be both a blessing and a curse. On the one hand, it can lead to higher returns in good times. On the other hand, it can exacerbate losses in bad times. Therefore, it is crucial for small businesses to strike a balance between risk and return when deciding on their degree of financial leverage.

Implications of Financial Leverage

Financial leverage can have significant implications for a small business. Firstly, it can magnify profits, thereby increasing the return on equity. This can make the business more attractive to investors and potentially lead to higher share prices. Secondly, it can provide a tax shield, as interest payments on debt are tax-deductible. This can reduce the business's tax liability and increase its after-tax profits.

However, financial leverage also comes with risks. It can magnify losses, leading to a decrease in the return on equity. It can also increase the business's risk of bankruptcy, as it must meet its debt obligations regardless of its financial performance. Furthermore, a high level of debt can make the business less attractive to investors and lenders, potentially leading to higher borrowing costs.

Application of Financial Leverage in Small Businesses

Financial leverage can be a powerful tool for small businesses, providing them with the funds needed to grow and expand. For instance, a small business might use debt to purchase new equipment, hire additional staff, or invest in marketing. These investments can lead to increased sales and profits, thereby providing a return on the borrowed funds.

However, the application of financial leverage in small businesses must be done judiciously. Small businesses, by their very nature, are more vulnerable to market fluctuations and economic downturns than larger corporations. Therefore, they must carefully consider their ability to service their debt in various economic scenarios before deciding on their level of financial leverage.

Factors to Consider

When applying financial leverage, small businesses should consider several factors. Firstly, they should assess their ability to generate a return on the borrowed funds that is higher than the cost of debt. This requires a thorough analysis of the potential return on investment and the current and projected interest rates.

Secondly, they should consider their ability to meet their debt obligations in various economic scenarios. This involves stress testing their financial projections to ensure that they can service their debt even in the event of an economic downturn or a decrease in sales. Lastly, they should consider the potential impact of their degree of financial leverage on their relationships with investors and lenders.

Best Practices

There are several best practices that small businesses can follow when applying financial leverage. Firstly, they should maintain a conservative level of debt, ensuring that they can meet their debt obligations even in the worst-case scenario. Secondly, they should diversify their debt sources to reduce their dependence on any one lender. This can provide them with more flexibility and bargaining power in their dealings with lenders.

Thirdly, they should regularly review and adjust their financial leverage strategy in response to changes in the business environment. This involves monitoring key financial indicators, such as the debt-to-equity ratio and the interest coverage ratio, and adjusting their level of debt as needed. Lastly, they should communicate their financial leverage strategy to their stakeholders, ensuring that they understand the risks and rewards associated with this strategy.

Impact of Financial Leverage on Small Business Performance

Financial leverage can have a significant impact on the performance of a small business. On the positive side, it can provide the business with the funds needed to seize growth opportunities, thereby potentially leading to increased sales and profits. It can also provide a tax shield, as interest payments on debt are tax-deductible.

On the negative side, financial leverage can increase the business's financial risk, as it must meet its debt obligations regardless of its financial performance. This can lead to cash flow problems, especially in the event of an economic downturn or a decrease in sales. Furthermore, a high level of debt can make the business less attractive to investors and lenders, potentially leading to higher borrowing costs and lower share prices.

Positive Impact

When used judiciously, financial leverage can have a positive impact on the performance of a small business. By providing the business with the funds needed to seize growth opportunities, it can potentially lead to increased sales and profits. Furthermore, by providing a tax shield, it can reduce the business's tax liability and increase its after-tax profits.

Financial leverage can also enhance the return on equity, making the business more attractive to investors. This can potentially lead to higher share prices, providing a return to the equity holders. Lastly, financial leverage can provide the business with more flexibility in its financial management, as it can choose to repay its debt or invest in growth opportunities as it sees fit.

Negative Impact

However, financial leverage can also have a negative impact on the performance of a small business. By increasing the business's financial risk, it can potentially lead to cash flow problems and even bankruptcy. This is especially true in the event of an economic downturn or a decrease in sales, as the business must meet its debt obligations regardless of its financial performance.

A high level of debt can also make the business less attractive to investors and lenders, potentially leading to higher borrowing costs and lower share prices. Furthermore, it can put pressure on the business to generate a high return on investment, potentially leading to risky business decisions. Lastly, it can lead to a loss of control for the equity holders, as the lenders may impose restrictions on the business's operations.

Conclusion

In conclusion, financial leverage is a powerful tool that can significantly impact the performance of a small business. When used judiciously, it can provide the business with the funds needed to seize growth opportunities, enhance the return on equity, and provide a tax shield. However, it also comes with risks, as it can increase the business's financial risk, potentially lead to cash flow problems, and make the business less attractive to investors and lenders.

Therefore, small businesses must carefully consider their ability to generate a return on the borrowed funds, meet their debt obligations in various economic scenarios, and manage their relationships with investors and lenders before deciding on their level of financial leverage. By doing so, they can harness the power of financial leverage to fuel their growth and success.