FINANCIAL LEVERAGE: Risk versus reward
A reader recently e-mailed me regarding the appropriate time for a company to borrow funds versus using equity to purchase an asset. This question requires detailed analysis between a company’s finance manager, the bank and the accountant.
Most business students learn in their first finance class that the cost of debt financing (i.e., the cost to borrow) is substantially lower than the cost of equity financing (i.e., using the company’s own equity).
Many complicated math formulas detail and support this claim, which is beyond the scope of this article. However, just know that in most cases, borrowing money arguably costs less than using the company’s equity to make asset purchases. This concept is where the term “leverage” originates, for when a company borrows money, they are using outside funds as a lever to increase their asset base.
Financial Leverage Concept
The primary concept supporting financial leverage is that a company increases return on equity (ROE)* when funding new projects with debt instead of equity. By using debt to fund a new project, the company’s equity position remains unchanged and allows profits generated by those debt-funded projects to increase shareholder returns. However, if net income does not increase (or worse, decreases) on those new debt-funded projects, then shareholder returns actually diminish. This further illustrates why taking on additional debt should require thorough analysis when deciding how to acquire new assets or fund new projects.
Suppose a taxi company wants to purchase a new fleet of cars at the cost of $500,000 and expects to generate $100,000 in annual profit from this new fleet. If the company lacks funds to cover this purchase, then it can fund the purchase by borrowing money from a creditor/bank (assuming an 8 percent interest rate) or selling shares. The company’s current equity position is $2,500,000 and typically earns $250,000 per year for an average ROE of 10 percent.
Following this table, the taxi company’s shareholders earn a greater ROE using (leveraging) money through debt borrowed from creditors/ banks. This table does not include the beneficial effects of income taxes on debt-funding, as a company’s interest expense is tax deductible in most taxing jurisdictions, thus increasing the amount of net profit.
Assuming the company is subject to a 35 percent incremental income tax rate, the debt cost of $40,000 actually decreases to $26,000. Taking existing profit of $250,000, adding the profits from the new fleet of cards of $100,000, and subtracting the new debt cost of $26,000, the company’s new total profit increases to $324,000, and further increases ROE (i.e., shareholder return) to 13 percent.
Dangers of Leverage
While the table above demonstrated the financial benefit to leveraging, companies must remain aware of the dangers of borrowing funds through creditors. If the new fleet of cars fails to generate a net positive return, then not only is the company facing a major decline in overall profitability, but may also begin struggling to make repayments on the new debt.
Another example where borrowing funds could prove detrimental to the taxi company occurs during an economic contraction. During the contraction, travelers/commuters become more inclined to utilize public transportation, bikes and other alternatives to using taxis, thus driving down profitability of the company. Furthermore, banks tend to reduce lending funds in an economic downturn, and in some cases may even begin calling loans. This combination could lead to corporate bankruptcy for firms that find themselves overleveraged.
While borrowing funds through debt provides real financial benefits, companies must remain aware of the insolvency dangers for firms that borrow too much. That is why companies should always consult their finance departments, banks and accountants when deciding whether to acquire assets or fund projects.
With over a decade in banking, Ryan Thomas, CRC, spent the majority of his career underwriting and analyzing commercial loan requests. He holds his Bachelor of Science in aerospace studies from Embry Riddle Aeronautical University and his Master of Business Administration from LSUS. Thomas graduated from the Graduate School of Banking at LSU, where he was elected as the 2017 class vice president. He holds a Credit Risk Certification (CRC) designation and manages the loan review department for a local bank. You may reach him at his e-mail address at email@example.com.”