Why are highly leveraged companies looked at with suspicion?
Why is leveraging frowned upon?
Leverage is a positive word. It is derived from an engineering term called ‘lever’. Its function is to provide magnification.
Colloquially, in a financial context, leverage merely refers to using borrowed funds to finance operations. Financial leverage helps in accelerating profit.
Leverage is derived from an engineering term called lever. To lift a weight, if one takes the help of a lever, the effort exerted at one end is less and the weight that gets lifted at the other end is more.
Similarly, with the help of financial leverages, a smaller increase in the sales turnover can lead to an exponential increase in profit.
In engineering, a lever works on the principle of fulcrum.
In finance, the fixed cost in the form of interest to be paid on debt acts as the fulcrum.
The Fixed Cost advantage
In the field of costing, fixed costs have a very important role to play.
These costs, by their very nature, do not increase or decrease along with a change in sales. That is, if sales increase, fixed costs do not increase (at least not in the same proportion), nor do these costs come down when sales decrease.
As a consequence the multiplier effect works to the advantage of corporations when sales are on the ascendent and works against them during recessions.
Leverage, therefore, is a double-edged sword and highly leveraged companies are also highly risky companies. Which is perhaps why the phobia exists.
Is leveraging bad?
Leveraging per se is not bad. In fact it helps organisations to exceed their reach beyond their grasp.
The problem lies with unproductive and foolish borrowing.
Borrowing is bad if:
- If the borrowed funds are used for unproductive purposes
- On deploying the borrowed capital, the organisation is unable to earn at least equal to the cost of borrowing
- If the borrowed funds cannot generate sufficient cash inflows to meet the repayment obligations
If the above conditions are not violated, if the borrowed capital can be deployed productively, if the organisation can earn greater than the interest payable and if it can ensure that cash inflows are more than sufficient to meet repayment obligations, then the more an organisation borrows, the more it will prosper.
Therefore when managements proudly announce during shareholder meetings that “ we are a debt-free company”, I have never understood whether they are boasting or apologising.
They are either saying that:
- we do not have need for any more money since we have stopped growing, or
- we are not growing fast enough and all our capital requirements can be met from internal accruals or
c. we will use equity capital to fund expansion, which is more expensive than loans.
From an investor’s perspective, these are not very encouraging statements.