Financial leverage, like any financial strategy, presents both opportunities and risks that require careful management. In this article, we analyze in detail what financial leverage involves, its operation and the different sources of funding available so that a company can take advantage of this tool successfully.

‍

What is financial leverage?

Financial leverage is a strategy widely used in the business environment that involves the use of borrowed capital to finance the acquisition of assets or the making of investments. Through leverage, companies can access additional funds without the need to increase their own capital, allowing them to expand their operating capacity and pursue new growth opportunities.

‍

The fundamental principle behind financial leverage is that the assets acquired with the borrowed funds generate sufficient income to cover the costs of the debt, including interest. In this sense, leverage can be considered as a tool to maximize return on equity, that is, to obtain more with less direct investment.

‍

For example, let's imagine that a company has 1 M€ in equity and decides to finance the purchase of new machinery through a 2 M€ loan. This machinery, if used effectively, could significantly increase production capacity and, therefore, the company's revenues. Suppose that the machinery allows the company to generate additional revenues of €500,000 per year. If the costs associated with the loan (such as interest) amount to €300,000 per year, the company would still obtain an additional net profit of €200,000, which would be added to its profits. In this scenario, leverage has allowed the company to increase its profitability without the need to disburse more equity.

‍

However, it is important to note that financial leverage also involves risks. If the income generated by the assets acquired is not sufficient to cover the costs of the debt, the company could face financial difficulties, including the possibility of insolvency. Therefore, the use of leverage requires careful planning and a thorough evaluation of potential risks and benefits.

‍

Benefits of Financial Leverage

The main attraction of financial leverage is its ability to amplify returns on investment (ROI). By using borrowed funds, companies can make larger investments than they could with their own capital, allowing them to take advantage of more ambitious growth opportunities. In addition to amplifying returns on investment (ROI), financial leverage offers a number of additional benefits that can boost a company's growth and competitiveness, as detailed below.

‍

• Increased return on equity (ROE): Return on Equity (ROE) is a key measure of profitability that indicates how effectively a company is using its capital to generate profits. If a company can finance an investment with debt that generates returns greater than the cost of the loan, the ROE will increase, making the company more attractive to investors. In other words, financial leverage can increase ROE by allowing companies to make investments that generate high returns without the need to increase their own capital proportionately.

‍

• Tax optimization: In many countries, interest paid on debt is tax deductible, reducing the actual cost of borrowing. This tax optimization is a significant benefit of financial leverage, as it allows companies to reduce their tax burden. By paying less taxes, companies can reinvest tax savings in their business, allocating more resources to growth initiatives or improving their competitiveness in the market. This tax advantage makes leverage an especially useful tool for companies seeking to maximize their financial efficiency.

‍

• Access to new growth opportunities: Financial leverage also provides companies with the ability to access new growth opportunities that could be out of reach if they relied solely on their own capital. For example, a company can use debt to finance expansion to new markets, the acquisition of competitors, or investment in new technologies. These opportunities can be crucial for the company's long-term growth and for its ability to compete in a dynamic and constantly changing business environment. In addition, access to additional capital allows the company to act quickly in the face of investment opportunities, which can be a significant competitive advantage.

‍

• Increased bargaining power: The strategic use of financial leverage can increase a company's bargaining power vis-a-vis its suppliers and competitors. A well-funded company is better able to negotiate better terms of purchase, volume discounts, or even the acquisition of competitors. In addition, the financial strength derived from the effective use of leverage can improve the company's position in negotiations with strategic partners or in attracting key talent, helping to strengthen its position in the market.

‍

• Diversification of financial risk: Financial leverage also allows companies to diversify their financial risk. By financing projects and acquisitions with a combination of debt and equity, companies can reduce their exposure to risk in any particular area of their business. For example, instead of using all of its capital for a single investment, a company can use debt to finance multiple projects, thus distributing risk and increasing the likelihood of success on different fronts. Not only does this protect the company against potential losses, but it also allows it to maintain greater financial flexibility for future opportunities.

‍

Risks of financial leverage

Despite the benefits it offers, financial leverage comes with significant risks that companies must consider and manage carefully. Among these, insolvency risk is the most critical, as it occurs when a company is unable to meet its debt obligations. This risk is compounded when the company relies excessively on leverage, which can compromise its financial stability and its ability to operate in the long term. But what other risks of financial leverage should be considered?

‍

• Risk of over-indebtedness: The risk of excessive indebtedness is one of the main challenges associated with financial leverage. If the revenues generated by debt-financed assets are not sufficient to cover the costs of that debt, the company could face serious financial difficulties. This scenario can be particularly dangerous in cyclical or volatile industries, where revenues can fluctuate significantly. In extreme cases, excessive indebtedness can lead to bankruptcy, especially if the company is unable to refinance its debt or if it faces high interest rates in an unfavorable economic context. The key to mitigating this risk lies in prudent debt management and maintaining a healthy balance between equity and debt.

‍

• Pressure on cash flow: Another major risk is the pressure that financial leverage can exert on a company's cash flow. Regular interest payments and the possible return of borrowed capital can consume a significant part of a company's financial resources, limiting its ability to cover other operating expenses or to reinvest in the business. This pressure is particularly acute during periods of underperformance or in situations where projected revenues do not materialize as expected. The tension in cash flow can lead the company to adopt emergency measures, such as selling assets, drastically reducing costs or even seeking refinancing on less favorable terms.

‍

• Loss of financial flexibility: Financial leverage can also result in a significant loss of financial flexibility. Companies with high levels of debt often face restrictions imposed by creditors, which can limit their ability to obtain additional financing in the future or to adapt to unexpected changes in the market. This lack of flexibility can hinder a company's ability to take advantage of new investment opportunities or to respond to economic crises. In addition, a high debt burden can affect a company's credit rating, making any future financing even more expensive and exacerbating financial limitations.

‍

• Increased operational risk: Financial leverage can also amplify a company's operational risk. With a higher debt burden, any decrease in revenue or increase in operating costs can have a more significant impact on the company's financial viability. For example, in an uncertain economic environment, where production costs increase or demand decreases, a highly leveraged company may find itself in a situation where it cannot cover both operating costs and debt payments, which could quickly lead to insolvency.

‍

• Vulnerability to changes in interest rates: Finally, leveraged companies are particularly vulnerable to changes in interest rates. If the company has financed its debt at variable rates, an increase in interest rates can significantly increase the expected cost of debt, negatively affecting the company's profitability and ability to meet its financial obligations. This vulnerability can force the company to renegotiate its debt terms on less favorable terms, or to face higher financial costs that erode its profit margins.

‍

In short, while financial leverage can be a powerful tool for business growth, its misuse or excessive use can lead to significant risks that, if not properly managed, can compromise the stability and future of the company.

‍

What sources of funding make it possible to leverage the company?

There are several sources of funding that companies can use to leverage. Each of them has its own characteristics, advantages and disadvantages. Below, we explore some of the most common sources:

‍

• Bank loans: Bank loans are one of the most traditional forms of financing for leverage. Companies can apply for short or long term loans to finance various needs, from working capital to the acquisition of assets. The advantages of a bank loan include the possibility of opting for a fixed or variable interest rate, depending on the agreement, and the fact that interest payments are tax deductible; however, it also has disadvantages, such as the need to provide guarantees, that is, assets that can be seized in the event of default, and the difficulty of obtaining it, especially for new or struggling companies. For example, as we have seen before, a manufacturing company could request a bank loan of 2 M€ to purchase new machinery that increases the efficiency of its production; if the machinery allows the company to increase its production and reduce costs, the additional revenues could be sufficient to cover the cost of the loan and generate additional profits.

‍

• Public funding: One of the most attractive alternatives for startups seeking financial leverage is public funding through programs such as ENISA, CDTI and different regional initiatives. These options represent a lower risk compared to other sources of private funding, since they do not require personal guarantees or guarantees, protecting the founders' assets. In those cases in which guarantees are requested, it is generally possible to do so by pledging your own aid, allowing you to secure the loan without compromising personal assets. In addition, these programs offer long payback periods that can extend up to several years, giving startups crucial financial breathing space in their early stages. They also tend to include grace periods, during which the company does not have to start amortizing the loan, allowing them to focus on the growth and consolidation of their product or service without the pressure of immediate payments.

‍

• Corporate bond issuance: Companies can also finance themselves by issuing corporate bonds, which are debt instruments sold to investors. Corporate bonds usually have a fixed interest rate and a specific maturity date. The advantages of issuing bonds include access to large amounts of capital and that interest payments are often tax-deductible; however, it also has disadvantages, such as the need to pay regular interest to bondholders and the increased financial risk of the company if not properly managed. For example, a large technology company could issue bonds for 100 M€ to finance the acquisition of a smaller company that develops complementary technology; if the acquisition allows the parent company to expand its market share and increase revenues, the cost of bonds will be more than offset.

‍

• Leasing: Leasing is a form of financing in which a company rents an asset (such as machinery or vehicles) instead of buying it directly. This allows the company to use the asset without having to shell out a large amount of capital. The advantages of leasing include that it does not require a significant initial outlay and allows the company to upgrade or replace assets more easily; however, it also has disadvantages, such as that lease payments can be higher than long-term acquisition costs and that the company does not own the asset at the end of the lease, unless a purchase option is agreed. For example, a trucking company might choose to lease their fleet of trucks instead of buying them, allowing them to keep working capital free for other investments and regularly upgrade their fleet to maintain operational efficiency.

‍

• Credit lines: Lines of credit are another flexible source of funding that companies can use to meet temporary capital needs or take advantage of investment opportunities. A line of credit is a pre-approved amount of money that a company can withdraw as needed. Its main benefits include the flexibility it offers to withdraw funds when necessary and that interest is only paid on the amount withdrawn, while its main disadvantages include higher interest rates than traditional loans and the fact that continuous access to the line of credit can create dependence. For example, a retail company could use a line of credit to finance the purchase of additional inventory during peak sales season. Once the products are sold, the company can pay the line of credit, minimizing interest costs.

‍

In conclusion, financial leverage is a fundamental strategic tool for companies seeking to expand their operational capacity, maximize profitability and access new growth opportunities. Through different sources of funding, such as bank loans, bond issuance, leasing and lines of credit, companies can effectively leverage themselves to raise additional capital. However, the use of leverage involves significant risks, such as excessive indebtedness and pressure on cash flow, which require careful management. In short, financial leverage can be a great ally for business growth if used wisely and strategically.