How does Financial Leverage affect financial risk?

A company’s financial leverage is its dependence on debt. It can impact the company’s return on equity (ROE) positively or negatively due to the increased risk probability.

Impacts of Financial Leverage

As an individual or a company will have to pay back the debt, it will always bring about a heightened level of risk. The income an individual or a company earns must be used to pay back the debt, even if the earnings or cash flows go down.

From a firm’s perspective, the use of financial leverage (debt) can positively – or sometimes negatively – impact the ROE due to an increased level of risk.

Impact on Return on Equity

Return on equity is shareholders’ equity-return of a company’s common stock investors. It refers to a firm’s efficiency of generating profits from each unit of shareholders’ equity. Return on equity is a measure of how well a company uses investment funds to profit and grow earnings.

The following equation is used to measure ROE −

$$\mathrm{ROE =\frac{Net\:Income \:After \:Tax}{Shareholder \:Equity}}$$

A company’s return on equity increases at an optimum level of financial leverage because the use of leverage increases the stock volatility, increasing the level of risk which then increases the returns.

  • Financially over-leveraged companies may face a decrease in return on equity.

  • Financial over-leveraging is meant to incur a huge debt by borrowing excess funds at a lower rate of interest and using them in high-risk investments.

  • When the risk of the investment goes above the expected return, the value of the company’s equity may decrease as stockholders take it to be too risky.

Leverage, Risk, and Misconceptions

The most common risk of financial leverage is that it multiplies losses. A company may face bankruptcy due to financial leverage’s effect on its solvency. If the company borrows too much money, it will have more chances of bankruptcy, while a less-levered company may avoid bankruptcy due to higher liquidity.

There is a misconception that companies usually enter an increased level of financial leverage due to desperation, which is referred to as involuntary leverage. This is basically caused due to eroding equity value as opposed to the extra addition of more debt. That is, it is generally a symptom of the problem, not the cause of it.

While evaluating the risk of leverage, the value of the company itself and its activities should be considered too. If a company borrows debt to modernize the operations, add new products to its product line, or expand its operations internationally, the additional diversification would most likely cancel the extra risk from leverage. The gain is, if a value is expected to be added due to the use of financial leverage, the extra risk should not have a negative impact on the company or its investments.