Leverage

Leverage is the amount of debt a business holds in its combination of debt and equity (financial structure). A company with a debt level above the industry average benefits from high leverage.

Leverage is not necessarily bad. When incomes rise, payments are made with sizable surpluses and additional debt is acquired to take advantage of market opportunities.

However, when incomes are low, a highly leveraged business may be late in paying its debt and not be able to borrow additional funds to ensure its survival.

Leverage purpose:

So that the profits obtained are greater than the fixed costs (fixed expenses).

Two ratios are used to measure a company’s leverage:

1. The debt ratio and the debt-to-total asset ratio.

2. Comparing these ratios with those of other companies in the same industry shows their usefulness.

Learn more about the leverage effect

In the example below, two companies in the same industry have assets of $ 1,000,000.

Company A has total debt of $ 250,000 and equity of $ 750,000.

• Its debt ratio is as follows:

$ 250,000 / $ 750,000 = 0.33: 1
In other words, for every dollar borrowed, shareholders paid $ 3

• Its total debt-to-asset ratio is as follows:

$ 250,000 / $ 1,000,000 = 25%
Its financial structure consists of 25% debt and 75% equity.
Company B has total debt of $ 750,000 and equity of $ 250,000.

• Its debt ratio is as follows:

$ 750,000 / $ 250,000 = 3: 1
In other words, for every dollar contributed by shareholders, the company borrowed $ 3.
Its total debt-to-asset ratio is as follows:

$ 750,000 / $ 1,000,000 = 75%
Its financial structure is made up of 75% debt and 25% equity.

Here, Company B is much more leveraged than Company A. When the markets are growing, Company B will be in a good position. But during a market downturn, it will struggle. A long period of slow growth risks making Company B insolvent.

Sources: PinterPandai,