November 19, 2020

Financial Leverage: What is It and Why a Business Needs One?

Articles

Financial Leverage: What is It and Why a Business Needs One?

Definition

Leverage means the use of borrowed capital as a source of investment financing in order to increase assets and generate higher returns. In finance, through financial leverage, you borrow money, invest, and try to increase your profits through higher financial power. The term “financial leverage” refers to the use of borrowed funds to purchase assets. It is used in order not to spend too much of your own money. After you pay off what you borrowed, you still have more money left than if you used only your capital for investing.

Leverage is a support that is often necessary for start-ups and growth of a business. The leverage concept in business is related to a principle in physics where a lever is the simplest mechanism that allows you to reduce the effort required to lift the object. Without leverage, such a task cannot be accomplished as easily or at all. The borrowed capital serves as such a leveler in business to allow it to do more than it otherwise can. 

Purpose

Financial leverage is mainly used for the following purposes:

  • To expand the asset base of a company or individual entrepreneur and generate returns on venture capital. This means that both earnings per share and profits per share increase.
  • To increase your potential profit.
  • For a more favorable tax regime, as in many countries, interest income can be deducted from taxes. Thus, the cost price for the borrower is reduced.

Examples

Most young businesses do not have enough cash to cover all of their costs, so the entrepreneur applies for a business loan called leverage or simply external funds to expand, launch, or acquire assets. This allows the business to do what it could not do without additional funds.

For example, a small home decor shop wants to expand into an adjacent space in a shopping center. Besides the increased rent payments, the business will have to buy shelving and other items necessary for product display, order more products to be sold in this space, etc. This gives the entrepreneur the advantage of earning higher returns with a lower initial investment.

Financial Leverage: What is It and Why a Business Needs One?

However, when talking about leverage, we can mean not only the amount of money needed to grow and get results. Leverage for any company or even an individual generally means getting good results by maximizing easy investments. Proper use of leverage multiplies results without wasting all the resources of the business.

Any strong side of your company can be presented as leverage for business. For example, do you have a huge network of people interested in the goods you make? It is a leveler that can be used for development. Do you have several hours of training videos and recordings? It is a pivot point that leverages investments in people, technology and time. Perhaps you have a well-established system for distributing tasks or delegating work? It is also a very valuable resource that increases efficiency within the company.

Leverage ratio

When considering a business loan application, a lender will usually look at the amount of debt the business currently has to determine whether it is worth the risk to provide a loan to a particular entity. The leverage ratio in the accounting and business world is any of the financial indicators that take into account how much capital is received in the form of a loan to assesses the company’s ability to meet its financial obligations.

This leverage ratio is important because companies rely on a combination of equity and debt to fund their operations, and knowing the amount of debt a company owns is useful in assessing whether it can pay off its debts when they arise. 

Debt to equity ratio, for example, is a leverage formula where the higher the loan amount, the greater the leverage. If a company is “highly leveraged”, it means that it has a large proportion of leveraged funds in relation to equity. Excessive leverage always increases the risk because it cannot always be recovered. However, when leveraged money is used in such a way that the generated rate of return exceeds the corresponding interest rate, the company is in an advantageous position because the value of the assets will be increased.

Share This Article

Author: Charles Lutwidge

Talk To A Bookkeeping Expert

A bookkeeping expert will contact you during business hours to discuss your needs.

QB_enterprise
QB_Advanced
QB_Desktop
QB_PointofSale
Billcom
BBB
Hubdoc
Founders_Pledge
Mindbody
Expensify
GustoPartner
Xero
Shopify Partner
CF_Partner
wboa