Investors and business executives use financial leverage to turn small amounts into larger returns and profits. They sell preferred stock and bonds, raising money to invest with the ultimate goal of adding to shareholder earnings. Assets and liabilities can be carefully balanced to mitigate risks, although reckless executives can misuse both stockholder trust and the balance sheet to cause crippling losses.
Financial leverage can yield high returns with a relatively small investment. For example, an investor can open a margin account at her brokerage firm to borrow up to 50 percent of an investment’s cost. She can control $50,000 worth of stock for $25,000. If the stock rises by 10 percent, or $5,000, she has made 20 percent on her money, minus the interest charge, which is set at the favorable rate of a secured loan. Conversely, a small decline is magnified; if the decline is large enough, the brokerage may demand additional money or equity to stave off a forced sale.
Financial Leverage and Operating Profit
For companies, executives can use financial leverage to increase profits more than per-share earnings would otherwise yield. A company without debt on its balance sheet that earns 10 cents per share increases its shareholder equity by the same amount. However, a leveraged corporation that earns the same 10 cents per share in operating profit increases its equity by a larger amount, minus interest expense or preferred-stock dividends. Companies that abuse leverage can drive themselves out of business, as losses are magnified. Preferred shareholders and banks have priority over common stockholders, so the company’s owners have the most to lose. Financial leverage can be a useful tool during economic prosperity or a burden in slow times.
Operational risk comes from the volatility of any business venture that is susceptible to consumer behavior toward its products or services. Many businesses, such as automobile manufacturing and construction, are also vulnerable to general economic conditions. Companies without long-term earnings stability tend to take on lower levels of financial leverage; those with a more predictable income stream can afford to assume more debt. A company that produces a popular toothpaste, for example, is less risky than one making trucks.
When companies use debt, their lenders require a sufficient rate of return to compensate for the additional risk involved when businesses borrow money that must eventually be repaid. Interest costs can be crippling if the company’s business is not strong enough. Increased debt is an effective leverage tool when inflation is high, as future currency is worth less -- but deflation can magnify the effect of interest expense.