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What is Leveraged Finance?
What’s important to know about it?
In this article, I will break down the meaning of Leveraged Finance so you know all there is to know about it!
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What Is Leveraged Finance
Leveraged finance is a term used in business to refer to a company’s abundant use of debt to finance its operations or make investments as opposed to the use of equity capital or cash.
In other words, leveraged finance is the use of debt capital to increase a company’s overall returns.
For example, in economic conditions when interest rates are low, a company may find that using debt to invest in new equipment, purchase assets, or fund business operations may be less costly than using equity capital or cash.
The term “leveraged” means that the company is using debt.
So another way of saying leveraged finance is to say “debt financing”.
Successful companies optimally use “leverage” to increase their profitability without having to give away any ownership percentage in the organization or use precious cash on hand.
Keep reading as I will further break down the meaning of leveraged finance and tell you how it works.
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Why Is Leveraged Finance Important
Leveraged finance is an important concept as it represents an important method for companies to obtain the capital and financing they need to operate their business while at the same time allow shareholders to maintain their ownership percentage.
Generally, the cost of debt will be lower than the cost of equity.
For a company to obtain a loan or debt capital, it will generally provide its assets as collateral in case of default.
Since a creditor is taking less risk, it will earn a lower return on the loan (therefore, translating into a lower cost for the company).
On the other hand, a company that is heavily leveraged will be exposed to greater liquidity risk or default risk.
Since the company is required to pay its creditors the principal borrowed along with interest, it must make sure that it generates the cash flow required to make timely payments.
Otherwise, the company may default on its debt obligations and trigger a series of unwanted consequences that may lead the company into bankruptcy.
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How Does Leveraged Finance Work
The way leveraged finance works is that a company will either borrow money from financial institutions (such as a loan) or issue debt securities (such as bonds) to raise capital.
Let’s assume that Company ABC needs $10 million to acquire another company.
If the company has $10 million in cash or marketable securities, it can use that to fund the purchase.
The company can also choose to sell shares to the general public or via private placement to raise $10 million.
Another option is for the company to borrow $10 million from a bank or issue $10 million in bonds to fund the acquisition.
A company can also combine all these sources of funding to raise the $10 million it needs.
If the company largely uses debt to finance the purchase price, then we can say that the company used leveraged finance to fund the acquisition.
In this context, the company may borrow $9 million from the bank and put up $1 million of its own cash to acquire the target company.
Consequently, 90% of the purchase price will come from leveraged finance.
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Leveraged Finance Risks
Although using debt instruments or borrowing money can help companies lower their cost of capital and keep their ownership in the company, it’s important to be mindful of the risks associated with having too much leverage.
Fundamentally, companies borrow money as it may be a cheaper source of capital.
The idea is to use someone else’s money to finance business projects that generate higher returns than what is paid to the creditor.
However, too much leverage can expose the company to potential liquidity and solvency issues.
When companies borrow money, they legally commit to reimbursing the lender’s capital along with interest based on a mutually agreed payment schedule.
No matter if the business is good or bad, the company must generate enough cash to be able to regularly pay its creditors properly and on time.
If a company is over-leveraged, it may run the risk of not being able to make all its debt payments on time.
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Leveraged Finance Meaning FAQ
What is an example of leveraged finance?
Let’s assume that a company has $10 million in shareholders’ equity on its balance sheet and no debt on its balance sheet.
The company is looking to purchase an asset that will cost $30 million.
If the company borrows $30 million to acquire the asset, the company will then have a $40 million value but will now have $30 of debt.
This means that the company is leveraged at a rate of 75%.
What are the benefits of leveraged finance?
Leveraged finance can be beneficial in many ways:
- Reduce a company’s cost of capital
- Increase profitability
- Shareholders are not diluted
What are the drawbacks of leveraged finance?
The main drawbacks of leveraged finance are:
- It increases the downside risk of an investment
- It exposes the company to default risk
- It can affect the company’s ability to risk further capital
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So there you have it folks!
What does leveraged finance mean?
In a nutshell, leveraged finance refers to capital obtained by a company via debt, loans, bonds, debentures, or other debt obligations.
Instead of saying “leveraged finance”, you can also say “debt finance” which means the same thing.
The idea is for a company to borrow money from creditors to finance an acquisition, merger, asset purchase, or transaction instead of using its own cash or equity capital.
Companies can use financial instruments such as bonds and debentures to raise debt capital or borrow money from financial institutions based on mutually negotiated terms.
Since debt tends to cost less than equity, companies can use leverage to increase their overall profitability and return.
However, it’s important to carefully assess how much is the optimal amount of debt a company can have on its balance sheet to avoid increasing its risk profile.
Now that you know what leveraged finance is all about and how it works, good luck with your research!
I hope you enjoyed this article on Leveraged Finance! Be sure to check out more articles on my blog. Enjoy!
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