Effects of Financial Leverage on the Trend of Stock Volatility

What is Financial Leverage?

Financial leverage is the use of increasing debt to purchase more assets. Leverage is usually employed to increase the return on equity (ROE). However, an excess of financial leverage magnifies the risk of failure, as it becomes increasingly difficult to repay the debt by the borrower.

  • Financial leverage is measured as the ratio of total debt to total assets in its formula. When the proportion of debt to assets increases, the amount of financial leverage does so too.

  • Financial leverage is favorable when debt can be put to generate returns greater than the interest expense related to the debt.

  • Many companies stick to financial leverage rather than acquiring more equity capital that reduces the earnings per share (EPS) of existing shareholders.

Advantages of Financial Leverage

Financial leverage has two primary advantages −

  • Increased earnings. Financial leverage may lead to earning a disproportionate amount on its assets.

  • Favorable tax treatment. The interest expense option is taxdeductible in many jurisdictions, which reduces its final cost to the borrower.

Disadvantages of Financial Leverage

Although there are chances of gain, financial leverage also presents the chance of disproportionate losses. The related amount of interest expense may go above the capability of the borrower if he does not earn sufficient returns to offset the interest expense. This is a special problem when interest rates go up or the returns from assets go down.

Stock Volatility Effects

The unusually large swings in net profits of securities due to a large amount of leverage increase the volatility of a company's stock price. This can be a critical problem when accounting for stock options issued to employees. Highly volatile stocks are taken as more valuable, and so it creates a higher compensation expense than would be done by less volatile shares.

  • Financial leverage is generally a risky approach in a cyclical business option, or in one in which there are low barriers to entry. In such cases, the sales and profits are more subject to fluctuation from year to year, increasing the chance of bankruptcy over time.

  • Conversely, financial leverage is an acceptable alternative when a company operates in an industry that has steady revenue levels, increased cash reserves, and high entry barriers, as operating conditions are steady enough to support a large amount of leverage with little downside.

A firm cannot go for unlimited financial leverage, as there is usually a natural limitation on the amount of financial leverage. As lenders are less likely to forward additional funds to a borrower that has already borrowed a large amount of debt, the limit of borrowing is often not subject to change.

In short, financial leverage offers an opportunity for increased returns for shareholders, but it also has the risk of outright bankruptcy if cash flows go below the estimations.