Financial leverage is using borrowed money to increase the potential return on investment. It is a powerful tool that can be used by businesses and investors to grow and expand their operations, but it also comes with risks.
In this blog post, we will take a deeper dive into financial leverage by providing a case study of a company using it, and discussing the basics of how it works, the advantages and disadvantages of using it, and the risks involved.
How Financial Leverage Works
Financial leverage is achieved by borrowing money to invest in an asset or business. The goal is to increase the return on investment (ROI) by using borrowed funds to generate a higher return than the cost of the debt.
For example, if a business borrows $100,000 to invest in a project that generates a 10% return, the ROI on the investment would be 11% (assuming a 1% interest rate on the debt). It‘s important to note that leverage amplifies potential gains and losses.
Advantages of Financial Leverage
One of the main advantages of financial leverage is that it allows businesses and investors to increase their returns on investment. By borrowing money to invest, they can potentially earn a higher return than they would have been able to with just their funds.
Additionally, financial leverage can help businesses grow and expand more quickly than they would have been able to without it. It also allows companies to raise capital and invest it in growth opportunities.
Disadvantages of Financial Leverage
While financial leverage can be a helpful tool, it also comes with risks. One of the main risks is that if the investment does not perform as well as expected, the borrower may not be able to repay the debt. This could lead to financial distress or even bankruptcy.
Additionally, leveraged investments are often more volatile than unleveraged investments, which means they can experience more significant fluctuations in value. Moreover, leverage also increases the company’s debt-to-equity ratio, which will affect the company’s credit rating and access to credit in the future.
Case Study: A Company Using Financial Leverage
One example of a company that has used financial leverage to its advantage is Walmart. The retail giant has historically used leverage to finance its operations and expansion. Walmart has used debt financing to fund its capital expenditures, such as building new stores and upgrading existing ones.
As of 2020, Walmart‘s debt–to–equity ratio was 1.33, which means that for every $1 in shareholder equity, the company had $1.33 in debt. Despite the company‘s high debt load, Walmart has been able to generate consistent profits and positive cash flow, allowing it to service its debt and expand its operations.
In 2020, the company generated $14.3 billion in net income, up from $13.6 billion in 2019. And that net income allowed the company to pay off its debt and continue to grow its business.
Financial leverage can be a powerful tool for businesses and investors looking to increase their returns on investment.
However, it also comes with risks, and it’s essential to consider the potential advantages and disadvantages before using it. It’s crucial to have a solid understanding of the underlying investment and the ability to service the debt in case of unexpected downturns.
As Walmart’s example shows, leverage can be used effectively if the company can generate consistent profits and positive cash flow to service its debt. Generally, it is wise to use leverage cautiously and only when the potential return justifies the risk.