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What Is A Leveraged Company
A leveraged company refers to a company that uses debt in its capital structure.
You can say that most companies are leveraged as they carry some debt on their balance sheet.
Many business experts and professionals argue that companies can create more value for their shareholders by using leverage.
The idea is to use other people’s money to make money.
However, when a company is highly leveraged, it means that it has a lot of debt obligations.
Too much leverage can expose the company to financial distress and insolvency risk.
In business lingo, when we refer to a company as a “leveraged company,” we are referring to a company that uses a higher debt level.
A leveraged company is not necessarily bad but suggests that the company has a higher than average level of debt.
To say that a company is “highly leveraged”, then we are referring to a company having a high level of debt exposing the company to financial risk.
Why Companies Use Leverage
There are many reasons why using leverage can be beneficial for companies.
The primary reason a company will use leverage is to access capital to invest in the business, accelerate the company’s growth, scale its operations, hire skilled resources, invest in technology, and so on.
The cost of debt is typically lower for companies than equity financing.
As a result, it may be more advantageous to take out a loan to fund the purchase of a manufacturing plant, real estate property, or equipment rather than sell equity securities.
Also, a company paying interest on its debt can deduct the interest expense from its gross revenues.
Investors and financial analysts like to see a company with a balanced capital structure where it uses both debt and equity to fund the business operations.
If a company uses too much leverage, then investors will need to ensure that the company generates enough cash flow to cover its debt.
Types of Leverage
There are essentially three types of leverage: operating leverage, financial leverage, and working capital leverage.
Operating leverage refers to a company’s investment activities.
The amount of money a company will regularly owe to conduct business is referred to as operational leverage.
For example, a company can have certain fixed costs to rent an office and pay for certain operating expenses on a regular basis.
These are ongoing fixed costs that the company must be able to pay to be able to continue doing business.
Financial leverage refers to a company’s capital structure.
A company borrowing capital to fund capital investments or make other investments in the business uses financial leverage.
Every company has a unique capital structure composed of debt and equity.
Working capital leverage refers to a company manipulating its working capital to fund business activities.
For instance, if a company reduces its working capital to pay fixed expenses, it can be problematic as it is reducing its investment in profitable projects and using that money to pay for ongoing expenses.
Leveraged Company Risks
When a company is referred to as a leveraged company by an investor or financial analyst, at first glance, it means that the company has more debt than its peers on its balance sheet.
It’s important to remember that leverage is not a bad thing, in fact, it’s considered by many highly useful for companies.
Many companies use debt and borrow funds to finance profitable projects and business ventures.
If the company’s rate of return is higher than its borrowing costs, then the company can use other people’s money to make money.
However, carrying too much debt or being highly leveraged is also risky.
When a company is highly leveraged, it means that it has a lot of debt and fixed costs that it must pay on a regular basis.
As a result, the company’s cash flow consistency becomes crucial.
Companies that consistently generate enough cash flow to pay for their financial obligations may be less exposed to risks than companies in cyclical markets or with unpredictable cash flow patterns.
Also, a company that suddenly becomes leveraged should be investigated to see if it’s a sign of distress or was there a recent capital investment that required the company to use leverage.
Over the past decades, some companies have also used creative accounting methods to hide debt on their balance sheet.
Since public companies are required to file their financial statements regularly, company executives can be tempted to “cook the books” to achieve market expectations.
This can eventually lead to disastrous outcomes and possibly the bankruptcy of the business.
Calculating Company Leverage
There are many ways you can calculate a company’s leverage.
Particularly, there are certain key financial ratios allowing you to assess the company’s capital structure and leverage.
The main ratios that are used are debt-to-asset ratio, debt-to-equity ratio, debt-to-EBIDTA ratio, equity multiplier, and degree of financial leverage.
The debt-to-asset ratio measures a company’s leverage by looking at the ratio between the company’s total assets and total debt (a high debt-to-asset ratio suggests high leverage).
The debt-to-equity ratio measures a company’s proportion of debt in relation to equity used to finance the business (a high debt-to-equity ratio can suggest the company is leveraged).
The debt-to-EBITDA ratio is a measure of a company’s debt to its net income before interest, taxes, depreciation, and amortization (a high debt-to-EBITDA ratio suggests higher leverage).
The equity multiplier provides an indication of a company’s leverage as a low equity multiplier means that the company’s equity level is low, thereby suggesting that there’s a higher level of debt.
The degree of financial leverage is calculated by dividing the percentage change of a company’s earnings per share by the percentage change in its earnings before interest and taxes over a period of time.
Leveraged Company Example
Let’s look at an example of a leveraged company to illustrate the concept better.
Let’s assume that Company ABC has a total of $10 million in its retained earnings and $40 million in cash it received from bank loans.
This company, therefore, has a total of $50 million, where $10 million belongs to the company, and $40 million is borrowed.
The company’s debt-to-equity ratio is 4.
Without considering anything else, we can say that this company is leveraged as it has $4.00 of debt for every $1.00 of equity.
Now, if we compare this company with its peers in the industry, we notice that the peers have a debt-to-equity ratio of 6.
Comparatively, this company is not as leveraged as its competitors, suggesting it is in a slightly better financial position.
Now, let’s assume that the industry debt-to-equity average is 2.5.
Having a debt-to-equity ratio suggests that the company is leveraged but further investigation will be needed to ensure that the company is able to generate sufficient cash flow to service its debt.
What Is A Leveraged Company FAQ
What does a “leveraged company” mean?
A “leveraged company” is a company that uses debt in its capital structure.
In business, when we refer to a company as a “leveraged” company, it’s to suggest that the company has a higher than normal level of debt.
This does not mean that the company is using too much debt, it simply means that the company is using debt more than other types of capital to fund its business.
What is financial leverage?
Financial leverage refers to the process of borrowing money to invest in profitable ventures.
In other words, you are using the bank’s money or lender’s money to make money.
For example, if a company can generate a 40% return on investment and can borrow at a rate of 5%, the company will be able to use leverage to generate good profits.
So there you have it folks!
What is a leveraged company?
In a nutshell, a leveraged company is a company that uses debt to finance its business operations.
The term “leverage” refers to “debt”.
Most businesses use leverage to different degrees to finance their business operations and scale over time.
Technically, being a leveraged company is not necessarily a bad thing.
However, in business jargon, when someone says a company is leveraged, they suggest that it has more debt than other funding sources.
Investors and financial analysts will typically want to analyze the company’s cash flows, EBITDA, leverage evolution over time, and other indicators, to see if the company remains financially healthy or not.
Now that you know what a leveraged company is and how it works, good luck with your research!
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