Financial And Operating Leverage - 1

In most financial reading material, you come across the term ‘leverage’ multiple limes. In this blog, I will attempt to create an understanding of what it means.

-

In your early school years, you would have studied ‘levers’ in physics or mechanics. You already know, how using a lever, you can get multiplied power, which you would not have otherwise.

-

In Finance it is a similar concept.

-

Let me explain that with examples.

-

Financial Leverage

• Let’s say you have a Business Project, which is estimated to give you a 15% return in 1 year.
• It requires an investment of $100.
• But adding up all your money, you only have $10 of your own money (equity).
• Remaining $90 (debt), you are able to borrow from the market at say 5%.
• After 1 year, as estimated, your project completed and returned $115.
• From this you pay back $90 principal plus $4.5 interest.
• Remaining amount left with you is $20.5 .
• That is, you got $20.5 on your investment of $10. Which is a hefty 105% return on your equity!
• Meaning, though your project returned only 15%, you actually got 105% return on your equity, ex all your debt obligations!!!

This is the magic of Financial Leverage. Other things same, higher your debt with respect to your equity, higher is the leverage and higher would be the return on your equity. But not so soon :)

-

The Risk Side

-

This higher return comes with equally higher risk. In Finance, always expect higher returns to be associated with higher risks. Let’s see how!

• Now, let’s say for your previous project, instead of 15% profit, it returned 15% loss So, after 1 year, you are left with $85.
• And you owe $94.5 to your creditors (90 + 4.5).
• You pay all of $85 you have and still owe them $9.5 .
• Your equity of $10 is all wiped out and you are filing bankruptcy as you cannot pay your remaining $9.5 obligation.

That is the Risk side of Leverage. Investors take high leverage companies as risky, so cost of their equities is higher.

-

To analyze this mathematically:

• If project returns are more than the interest rate you pay on your debt, your net GAINS will be magnified by the leverage.
• But if your project returns are lower than your loan interest rate, your net LOSSES will be magnified by the leverage.

I will discuss Operating Leverage in the next blog.