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To show to what extent a company has used debt to finance its operations.
What?
Financial leverage ratios.
Leverage?
Financial leverage.
Financial leverage?
It is the use of borrowed money(debt).
Borrowed money?
To finance the purchase of assets.
The purchase of assets?
With the expectation.
Of what?
That the income or capital gain from the new asset.
Income?
Will exceed the cost of borrowing.
What?
Financial leverage is the use of borrowed money.
Debt?
To finance the purchase of assets.
Finance the purchase of assets?
With the expectation that the income or capital gain from the new asset will exceed the cost of borrowing.
The income or capital gain?
From the new asset?
The new asset?
To finance the purchase of assets.
The purchase of assets? The new asset?
With the expectation.
The expectation?
That the income.
The income?
Or capital gain.
Capital gain?
From the new asset?
The purchase of assets.
Assets?
The income or capital gain from the new asset.
The income or capital gain?
Will exceed the cost of borrowing.
Borrowing?
The cost of borrowing?
In most cases, the provider of the debt.
The provider of the debt?
Will put a limit.
A limit?
Put a limit on how much risk.
Risk?
How much risk it is ready to take.
How much risk?
How much risk it is ready to take and indicate a limit on the extent of the leverage it will allow.
The extent of the leverage?
It will allow.
In the case of asset-backed lending.
Asset-backed lending?
The financial provider uses the assets as collateral until the borrower repays the loan.
Collateral?
Collateral is an asset or property.
An asset or property?
That an individual or entity offers to a lender as security.
As security?
For a loan.
As security for a loan?
It is used as a way to obtain a loan.
Obtain a loan?
Acting as a protection against potential loss for the lender should the borrower default in his payments.
Default?
Debt default.
It happens when a borrower fails to pay his or her load at the time it is due.
At the time it is due?
The time a default happens varies.
Varies?
Depending on the terms agreed upon by the creditor and the borrower.
The creditor?
In the case of a cash flow loan, the general creditworthiness of the company is used to back the loan.
How financial leverage works?
How?
How it's measured?
How financial leverage is measured?
The risks associated with using it.
The risks?
How financial leverage works?
How?
When purchasing assets, three options are available to the company for financing.
Three options?
Using equity.
Equity?
Using debt.
Debt?
And using leases.
Leases?
Apart from equity, the rest of the options incur fixed costs that are lower than the income that the company expects to earn from the asset.
Fixed costs?
Are lower than the income.
Lower than the income?
Earn from the asset.
The rest of the options, apart from equity, incur fixed costs that are lower than the income that the company expects to earn from the asset.
Expects to earn from the asset?
In this case, we assume that the company uses debt to finance asset acquisition.
Asset acquisition?
Assume the company X wants to acquire an asset that costs $100,000.
An asset that costs $100,000.
The company can either use equity or debt financing.
Use equity or debt financing?
If the company opts for the first option, it will own 100% of the asset.
100% of the asset?
And there will be no interest payments.
No interest payments?
If the asset appreciates in value by 30%, the asset's value will increase to $130,000 and the company will earn a profit of 30,000.
Appreciate in value by 30%?
Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000 and the company will incur a loss of $30,000.
Depreciates by 30%?
Alternatively, the company may go with the second option and finance the asset using 50% common stock and 50% debt.
Using 50% common stock and 50% debt?
If the asset appreciates by 30%, the asset will be valued at $130,000.
And?
It means that if the company pays back the debt of 50,000, it will have $80,000 remaining.
130,000 - 50,000 = 80,000?
Which translates into a profit of 30,000.
80,000 - 50,000 = 30,000?
Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000.
100,000 - (100,000 * 30%) = 100,000 - 70,000?
This means that after paying the debt of $50,000, the company will remain with $20,000 which translates to a loss of $30,000.
50,000 - 20,000?
Remain with $20,000.
How financial leverage is measured?
Debt-to-Equity Ratio.
Debt-to-Equity Ratio?
It is used to determine the amount of financial leverage of an entity.
The amount of financial leverage?
And it shows the proportion of debt to the company's equity.
The proportion?
It helps the company's management, lenders, shareholders, and other stakeholders understand the level of risk in the company's capital structure.
The level of risk?
It shows the likelihood of the borrowing entity facing difficulties in meeting its debt obligations.
Debt obligations?
Or if its levels of leverage are at healthy levels.
Healthy levels?
The debt-to-equity ratio is calculated as follows.
Ratio?
Total debt / total equity.
D/E ratio?
Total debt, in this case, refers to the company's current liabilities.
Current liabilities?
Debts that the company intends to pay within one year or less.
And long-term liabilities.
Long-term?
Debts with a maturity of more than one year.
Maturity?
Equity refers to the shareholder's equity.
The shareholder's equity?
The amount that shareholders have invested in the company.
Invested in?
Plus the amount of retained earnings.
Retained earnings?
The amount that the company retained from its profits.
Companies in the manufacturing sector typically report a higher debt to equity ratio than companies in the service industry.
Higher ratio?
Reflecting the higher amount of the former's investment in machinery and other assets.
And?
Risks of financial leverage?
Although financial leverage may result in enhanced earnings for a company, it may also result in disproportionate losses.
Losses?
Losses may occur when the interest expense payments for the asset overwhelm the borrower.
The interest expense payments?
Because the returns from the asset are not sufficient.
The returns from the asset?
This may occur when the asset declines in value or interest rates rise to unmanageable levels.
Declines in value?
Or interest rates rise.
Interest rates?
Rise to unmanageable levels.
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