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Home > Financing Checklists > Understanding and Using Leverage Ratios

Financing Checklists

Understanding and Using Leverage Ratios


Checklist Description

This checklist describes leveraging and leverage ratios, what they mean, and the risks involved for the investor.

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Definition

Leveraging is a way to use funds whereby most of the money is raised by borrowing rather than by stock issue (for a company) or use of capital (by an individual). At its most basic, leveraging means taking out a loan so that you can invest the money and hoping your investment makes more money than you will have to pay in interest on the loan.

The leverage ratio is used to calculate the financial leverage of a company. This information gives an insight into the company’s financing methods, or it can be used to measure the company’s ability to meet its financial obligations. There are a number of different ratios, but the main factors involved are debt, equity, assets, operating income, and interest expenses.

The most commonly used ratio is debt to equity (D/E, or financial leverage), which indicates how much the business relies on debt financing. In normal circumstances the typical D/E ratio is 2:1, with only one-third of the debt in the long term. A high D/E ratio might show up possible difficulty in paying interest and capital while obtaining extra funding. As an example, if a company has $10 million of debt and $20 million of equity, it has a D/E ratio of 0.5 ($10 million ÷ $20 million).

Another leveraging ratio can be used to measure the operating cost mix. This helps to indicate how any change in output may affect operating income. There are two types of operating costs: fixed and variable. The mix of these will differ depending on the company and the industry. A high operating leverage can lead to forecasting risk. For example, a tiny error made in a sales forecast could trigger far bigger errors when it comes to projecting cash flows based on those sales.

There is also interest coverage, which measures a company’s margin of safety and indicates how many times the company can make its interest payments. This figure is calculated by dividing earnings prior to interest and taxes by the interest expense.

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Advantages

  • Leveraging means borrowing money to invest. Anyone who takes out a mortgage is effectively leveraging. By paying a deposit to obtain a loan, you can buy a home that otherwise you would not be able to afford. Although property prices can and do fall periodically, over the long term property usually increases in value. If it does, you can sell the property and make a profit on your original mortgage loan.

  • Leveraging enables an individual or a company to gain access to larger capital sums to make investments, with the aim of making a profit by doing so.

  • Strategies in leveraging run from basic to highly sophisticated, and the degree of risk varies in the same way. The benefits of leveraging will depend on your financial situation, your objectives, and your attitude to risk.

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Disadvantages

  • Anything that has the potential to make money involves some risk. Gains can be better than normal; losses can be worse. A change in interest rates can have an effect on your profit too. There is a risk that your investment will not make enough profit to pay off the interest on your loan.

  • You can mitigate the risks by diversifying your portfolio, thereby guarding against high losses, although this will probably limit opportunities to make spectacular gains. A fixed-rate loan can protect against a rise in interest rates.

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Action Checklist

  • Are you comfortable borrowing money that you might struggle to pay back?

  • Are you comfortable with high risk in your finances?

  • Are you confident that interest rates will not rise to add further risk to your borrowings?

  • Are you confident your investment will make more than the interest you have to pay back on your loan?

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Dos and Don’ts

Do

  • Look at leveraging as a way of using other people’s money (by way of a loan) to make your own investments.

  • Understand how your loan works and what and when you will have to pay back.

  • As much research as you can. And then more research.

Don’t

  • Don’t get involved with leveraging if you are uncomfortable with financial risk.

  • Don’t choose an investment without a full understanding of what you are investing in.

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Further reading

Books:

  • Marr, Bernard. Strategic Performance Management: Leveraging and Measuring Your Intangible Value Drivers. Oxford: Butterworth-Heinemann, 2006.
  • Matthäus-Maier, Ingrid, and J. D. von Pischke (eds). Microfinance Investment Funds: Leveraging Private Capital for Economic Growth and Poverty Reduction. Berlin: Springer-Verlag, 2006.
  • Militello, Frederick C., and Michael D. Schwalberg. Leverage Competencies: What Financial Executives Need to Lead. Upper Saddle River, NJ: FT Prentice Hall, 2002.

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