What Does It Mean When a Company Is Leveraged?

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For some companies, the prudent course is to never take on any debt and to finance all operations out of cash flow. For other companies, the opportunities provided by using additional capital may outweigh any expense or other issue associated with borrowing. For these companies, the extra leverage provided by borrowing makes the best business sense. When that borrowing gets large enough, it will be considered leveraged.

Types

Leverage can come in many forms. For some companies, simple borrowing for the acquisition or construction of new facilities or equipment forms their leverage. For others, specific borrowing to increase the amount of capital used in specific activities such as leasing out equipment or buying investments represents a more direct form of leverage.

Function

Borrowing additional capital, whether from banks, investors or other lenders, permits a company to take advantage of opportunities that it may not otherwise be able to participate in. If these opportunities result in revenues exceeding the cost of the loans, then that use of leverage has increased the value of the company.

Warning

Leveraged companies come with an additional level of risk. Whereas a company without leverage risks only the capital invested in any specific project or activity, the leveraged company risks not only the invested capital, but the amount of money required to repay the loan. Thus, wrong decisions and losses are amplified in a leveraged company, which can make their performance more volatile.

Benefits

Judicious and successful use of leverage will provide a higher return than is possible without leverage. For example, an investment that earns a 20 percent ROI will result in an inflow of $120,000 in the case of a $100,000 investment (outflow). Assuming the same investment were made using an additional $400,000 that was borrowed, the inflow would be $200,000 minus the cost of the interest on the borrowed $100,000, resulting in a balance sheet with $200,000 from this activity versus $120,000.

Considerations

The primary consideration for all leverage is whether the potential additional return justifies the additional risk. In the case of a company's overall status, a leveraged company will likely be more volatile, with both more potential upside and downside.

Identification

How much debt makes a company "leveraged" varies depending on the company and industry. A company in a more conservative industry could be considered leveraged at just 20 percent debt levels, while a company in a more explosive industry may not be considered leveraged until debt levels approach 100 percent.

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