The Risks of Having an Excessive Amount of Financial Leverage in an Organization
Financial leverage refers to the use of debt to obtain more capital and expand business operations. An organization may benefit from having a certain amount of financial leverage if it anticipates increased sales and earnings from additional investments. But in times of business difficulties, financial leverage, especially an excessive amount of financial leverage, can enlarge operating losses, while still demanding cash outflows to meet debt payments. Financial leverage also has a negative impact on an organization’s overall financing cost and increases the risk of bankruptcy.
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Operating Losses
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Financial leverage can either help or hurt an organization’s financial performance, depending on business conditions. If an organization is profitable, extra investments from borrowed capital help further expand profitability. However, if an organization is experiencing losses, having used financial leverage, it will sustain larger losses. The more invested in a losing operation, the more the losses may be. Unlike equity investments in which an organization makes equity investors to absorb the losses, using financial leverage, an organization must come up with the amount of loss shortage to pay back the borrowed capital at maturity.
Cash Flows
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Excessive financial leverage sometimes can put a strain on an organization’s cash flows. Using equity capital, while an organization has to share any additional profits with equity investors, it doesn’t have to make any cash distributions to investors if it hasn’t earned enough profits. However, using financial leverage, while an organization can keep any earnings beyond the amount of promised interest, it must still make interest payments even though it has incurred losses. Such a demand on cash flows by financial leverage can make a difficult financial situation worse.
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Cost of Capital
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An organization’s cost of capital is the average financing cost of using a mix of equity and debt capital. Using financial leverage often is considered a way of obtaining relatively low cost of capital. Compared to equity investors, investors providing debt financing bear less risk because they are guaranteed about their interest and principal payments. However, the use of debt increases the financial risk for the organization in times of business losses, which may raise concerns by equity investors about their investments. The higher the perceived risk about an organization, the higher the required rate of return by equity investors and the more costly to maintain and obtain equity capital for the organization.
Solvency Risk
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While an organization can lose its equity capital without direct financial consequences, taking on excessive financial leverage and not being able to pay back the borrowed capital when due can put the organization at the immediate risk of bankruptcy. An organization’s solvency depends on its ability to absorb losses with the amount of equity capital it has. With a higher ratio of debt to equity, an organization has not only less equity to rely on, but also potentially greater losses to take in. Absent cash flows from other sources, excessive financial leverage is a potential threat to an organization’s financial solvency.
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