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financial leverage

Also called: leverage, gearing

Using borrowed money to finance the business. It raises the owners' return when things go well and deepens losses when they don't, because interest must be paid either way.

Financial leverage is using borrowed money to finance the business. Debt costs a fixed amount of interest whatever the results, so it works as an amplifier for the owners: in a good year profit beyond the interest is all theirs, in a bad year the interest still has to be paid and their result falls faster than the business's.

Compared with raising the same money from investors, debt keeps the owners' shares whole but adds a fixed cost. There is a profit level at which both give the owners the same; above it debt is better, below it equity is. Because interest is a fixed cost, it also raises the break-even point of every month, and it is paid in cash, which matters more than the accounting result in a weak season.

Two checks keep leverage honest. Interest coverage (operating profit ÷ interest) should be comfortably above 1 even in a weak year; below 1 the business can't pay the interest from operations. And the repayment date must fit the cash plan, not just the profit plan. Not to be confused with operating leverage, which comes from fixed operating costs rather than from debt.

Example

Klasna needs 6,000,000 UAH for its EU plan: a loan at 20% a year (1,200,000 of interest, interest only) or 12.5% of the company for an investor. The founders own 80% today, 70% after the investor. Taxes left out:

Founders' part
Strong year (profit 5,000,000)
Weak year (profit 800,000)
With the loan: 80% × (profit − 1,200,000)
3,040,000
−320,000
With the investor: 70% × profit
3,500,000
560,000

The loan wins only above 0.8 × (P − 1,200,000) = 0.7 × P, that is P = 9,600,000. In the weak year operating profit covers the interest 800,000 ÷ 1,200,000 = 0.67 times, and the bank still wants 100,000 every month.

Common mistakes

  • Looking only at the good year. Leverage multiplies losses exactly as it multiplies gains.
  • Comparing interest with the investor's share in one year only. Find the profit level where both options give the owners the same.
  • Ignoring cash timing. Interest and repayment are due on fixed dates, often in the weakest months.
  • Skipping interest coverage. Below 1 in a weak year, the debt is a cash problem, not a financing choice.
  • Confusing it with operating leverage. One comes from debt, the other from fixed operating costs; together they compound.

Learn it in the course