Avoiding the Leverage Trap

Leverage Trap - Complete Controller

As a corporate word, leverage refers to debt or borrowing funds to finance the acquisition of inventory, equipment, and other company assets. Business possessors can use either debit or equity to finance or buy the company’s possessions. Using liability or leverage increases the company’s possibility of bankruptcy. It also increases the business’s returns, specifically its return on equity.

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With debt funding, whether the interest charges are from a loan or line of credit, the interest expenses are tax-deductible. In addition, by making well-timed payments, a business will inaugurate a positive payment history and credit rating. Stakeholders in a company prefer the industry to use debt financing, but only to a degree. Beyond a certain point, financers get nervous about too much leverage, which drives up the business’s default risk.

Types of leverage

Operating leverage

Break-even analysis shows that there are fundamentally two types of costs in a corporation’s cost structure, i.e., fixed and variable costs. Operating leverage states the ratio of fixed costs that an enterprise has. Operating leverage is the proportion of fixed costs to variable costs. If a corporate firm has a lot of fixed costs compared to variable costs, then the company is said to have high operating leverage.

Financial leverage

Financial leverage refers to the amount of debt in the capital structure of the business firm. In layman’s terms, financial leverage refers to the right-hand side of the balance sheet. Operating leverage refers to the left-hand side of the balance sheet – the plant and equipment side. Operating leverage determines the mix of fixed assets or plant and equipment the business firm uses. 

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Financial leverage refers to how the business pays for it and finances the operation using bookkeeping strategies. One of the financial ratios used to calculate the volume of 
financial leverage in a business firm is the debt/equity ratio. The debt/equity ratio shows the proportion of debt in a business firm to equity.

Combined or total leverage

Combined or total leverage is the total risk facing a business firm. So, we can also say that we can use the total amount of leverage to magnify the returns from our enterprise. Operating leverage magnifies the returns from our plant and equipment or fixed assets.
Financial leverage magnifies the returns from our debt financing. Combined leverage is the total of these two types of leverage or the 
total magnification of returns. This is looking at leverage from a balanced bookkeeping sheet viewpoint.

Risk factors associated with leverage:

  1. Investment risk: In leveraging, you must invest the income of borrowed money. Leveraging does not avert you from justly making a bad investment decision.
  2. Magnification of losses: Using leverage to trade or purchase larger than you otherwise could magnify your losses. Be smart with your leverage. 
  3. Interest rate risk: Several factors affect your total return, such as tax, investment return, and loan cost. The key to efficacious leveraging is to have your after-tax investment return exceed your after-tax interest cost.
  4. Cash flow risk: Increasing interest rates have a ripple effect on your cash flow. If you will leverage, you must sustain the interest payments on the loan.
  5. Tax risk: Remember that success in leveraging requires that your after-tax returns exceed your after-tax cost on the interest. Variations in tax rules could potentially hurt your leveraging program.
  6. Emotional risk: Fear and greed can wreak havoc on any investment plan. Keeping a level head and direct resolutions using logic instead of emotions is even more imperative.

Download A Free Financial ToolkitConclusion

The bottom line is that leveraging is a tremendous tool to build wealth. Before you jump in with both feet, take the time to understand the risks. Consult your financial adviser to see if leveraging and well-planned bookkeeping make sense for you.

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