The Subtle Art of Leveraging

Leveraging is an age-old blend of vision and strategy. If you find yourself rummaging for techniques to increase your profits, leveraging might be just what you need. Through the discourse of this article, we will cover what leverage means, its types, how to create leverage, risks to keep in mind before leveraging, suggestions on how to get better at it, and lastly, its weight.

Let us start by simplifying what financial leverage spells; an investment strategy implemented by those seeking to increase potential returns on an investment by using borrowed capital. It is a liability for the borrower, but a source of income for the lender. Let us analyze a simple example to deepen our understanding. Let us assume you want to start your own company. To do so, you need capital. You turn to a bank to borrow money. The bank lends you that money with the underlying condition that the borrowed sum is repayable with interest. 

As of now, you, the borrower, are in debt to the bank. You now invest the borrowed sum into your company which eventually grows to gain profits. You then, repay the bank, the borrowed sum plus interest. Even after having repaid the full amount, you are still left with a net profit. This is a classic model, where you exercised the principle of leveraging to gain increased returns. There are three primary types of leverage: financial leverage, operating leverage, and combined leverage.

1. Financial Leverage: It is the use of debt to purchase more assets. Its purpose is to increase returns to shareholders via equity financing. It is the ratio of average total assets of a company to average equity. As the earning on the borrowed sum is greater than the interest payable on debt, there is an increased return on investment for the shareholders. However, an unnecessary amount of financial leverage magnifies the chances of failure, as it grows to be more arduous to reimburse the debt. 

2. Operating Leverage: It is the ratio of fixed cost to variable cost, or percentage fixed cost. Its purpose is to estimate the breakeven point of a company and the expected profit margins on individual sales. A direct relation exists between a company's operating leverage and its responsiveness to change in sales. So, companies with low operating leverages are less responsive to changes in sales. 

3. Combined Leverage: It is also designated 'total' leverage, which is defined as the total amount of risk facing a firm. It incorporates both, fixed operating and fixed financial, expenses. The degree of combined leverage intimates the gains and risks entailed in it. It is determined by the product of the degree of financial leverage and the degree of operating leverage. 

Create Leverage: Leverage is the pathway to making what you already have, go even further. You already have everything you need. The key is to identify, optimize, and implement. Here we look at a few steps on how you can create leverage for your own business:

  • Do your own research: Instead of shelling out money bags for research, do the research within the company itself. Follow up by selling reports on consumer satisfaction in various departments and industries. Furthermore, finance this by using leverage - borrowing money to fund the research, trailed by repaying it when the company gets paid. 
  • Find what motivates your customers: Understand what your customers need or want, then pour value into it by resolving their problems, or even surpassing their expectations. 
  • Be honest with where you are: This is an important one. You need to have a lucid judgment of where you can or cannot use leverage. The last thing you want is to make judgments based on the overestimation of your position, leading to elaborated losses. Assess what the other party wants and if you are in a position to provide it comfortably or not. If the answer to that is yes, use leverage intelligently to procure better pricing. 

Risks to keep in mind before nose-diving into leverage:

Playing leverage to its strengths whilst keeping a tab on the degree and number of risks is what yields positive results. Risks may occur when the asset depreciates in value, or the interest rates reach an unmanageable number. The following are risks you may be subject to when pursuing leverage:

  • Bankruptcy: The instability in revenues might snowball a company into bankruptcy because of its inability to compensate for the rising debt commitments or pay its operating expenses. 
  • Fluctuations of the stock market: Higher financial leverage, means more fluctuations in the stock price of the company. An increase in stock price translates to the company having to pay a larger interest rate to the shareholders. 
  • Decreased opportunities to more debts: This is true only if your company has defaulted in a debt previously, or is carrying a large sum of debt that is due to be cleared. This might be a concern for lenders and investors as there is a higher risk of default.

Why should you use leverage where you can?

Building wealth means working smarter, not harder. Here’s how using leverage could secure a brighter financial future for you or your company:

  •  It boosts earnings per share or EPS.
  •  It helps draw a balance between financial risks and returns.
  • It helps in the expansion of firms, leading to large scale manufacturing and thus, reducing the fixed costs drastically.
  • Tax relaxations are imposed by the government due to increased liabilities held by the company.
  • The need for financial leverage indicates an expansion of new business ventures, which attracts investors.

As we come to a close, we have understood what financial leverage is, its types, the risks involved whilst pursuing it, and how it can help your company to grow. Leverage enables you to explore your true growth potential whilst helping you build on wealth. The key is, to create leverage with whatever you have, at the right time, and in the right way. 

5 responses to “The Subtle Art of Leveraging”

  1. Atool Sinha says:

    Well written article, Divyushii. Very informative!

  2. Aishwarya Swaroop says:

    Very insightful divyushi. Keep it up 👍

  3. Natty says:

    Well researched . Lucid and informative . Very well outlined .
    Gained a good insight into the benefits of using this very important financial tool .
    Thank you !

  4. nandita mathur says:

    Simple and lucid ! Well written , Divyushi !

  5. Mira sinha. says:

    Very informative and thought provoking article. Well done Divyushi.

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