Financial leverage

What it means

Financial leverage describes how borrowed capital, most often a bank loan, changes the owners’ return. If a company invests borrowed money in activities that earn more than the interest costs, the difference goes to the owners and the return on their equity rises.

Example: a company with capital of 100,000 euros earns 10 percent. If it borrows another 100,000 euros at 5 percent and earns 10 percent on that too, profit grows by more than the interest cost and ROE rises. This is called positive financial leverage.

Leverage works both ways. If the return falls below the interest rate, the interest still has to be paid and the owners’ loss grows faster than in a company with no debt. The higher the leverage ratio, the stronger the effect and the greater the risk.

How it works in practice

When deciding how to finance an investment we compare the expected return, measured for example as EBIT on capital, with the cost of the loan. If the gap is small or uncertain, the loan adds more risk than return, and growing more slowly from own funds is the better choice.

Banks monitor leverage through covenants, such as debt to equity or to EBITDA. High leverage raises the price of further loans because the bank demands a risk premium, and the overall cost of capital, WACC, may start to rise.

In small companies leverage is often created with a shareholder loan instead of increasing capital. It is flexible, but interest paid to the shareholder may run into the thin capitalisation rules, and in a crisis repayments to shareholders are restricted.

What to watch out for

Leverage boosts profit in good years, but in bad ones it can bring the company down. If sales fall, the fixed instalments remain and the company may run out of cash before things improve, so for loans we always model a pessimistic scenario too.

High leverage moves a company closer to a state of crisis, assessed by the ratio of equity to liabilities. In a crisis there are restrictions on returning money to shareholders and the director must actively deal with the situation, so leverage is a legal decision as well as a financial one.