What You Must Know About Leverage by Matthew Roddan
According to Matthew Roddan of Project Ninenty Nine, there are different types of leverage and understanding it is very important for an investor and entrepreneur.
Financial leverage is the level a company is ready to use its fixed-income securities like preferred equity and debt. The higher the debt financing a company deploys, the higher the financial leverage, which also means more interest payment that could affect a company’s profits negatively.
Leverage is often deployed in trading of financial instruments and for purchasing of assets in real estate. As for a business, leverage is when a firm borrows funds for buying company’s assets for improving returns. On the other hand, investors who invest in a business wouldn’t opt for leveraging beyond a certain point, as it can hike a firm’s default risk.
When a companies break-even analysis is done two costs are taken into account – variable and fixed costs. Operational leverage is the fixed cost percentage a firm has, or the ratio of fixed to variable costs. When a firm has more fixed costs than variable costs, the operating leverage is high. This means, these firms are capital intensive.
Examples are automobile firms and even if the sales plunge, they would still have to shell out the fixed costs, which can hurt a firm when there’s an economic slowdown. On the other hand, if the firm’s labor or other costs are higher, the costs would be equivalent to the work done and it is called labor-intensive firm. A good example would be mining or service industry. Firms with high operating leverage would be influenced by miniscule changes in sales and it could affect their profits real quick.
So, for a business, financial leverage is the debt in capital structure and financial leverage deals with financing of the operational leverage. In a balance sheet, the financial leverage is the right-hand side and operational leverage is the left-hand side. As explained earlier, financial leverage can improve the return on equity and income per share for a firm, without reducing an owner’s income. However, more than required financial leverage could lead to bankruptcy or defaults. Debt/equity ratio helps determine a firm’s financial leverage, says Matthew Roddan of Project Ninety Nine.
Total or combined leverage is the amount of risk a business firm faces. In other words, it is the total leverage amount that could be used to improve a firm’s returns. Operating leverage improves the ROI for fixed assets and machinery, whereas, financial leverage improves the ROI on debt financing and when both are combined, it is combined leverage and the resulting profit maximization for a firm in entirety.
Understanding these key concepts is important for an investor or sponsor to pick and choose the right businesses for investment.