Multilayered leverage amplifies money’s rises, falls
On the Money
From the October 1, 2011 print edition
The ancient Greek Archimedes said, “Give me a lever that is long enough, give me a fulcrum that is strong enough and give me a place to stand and single-handed, I’ll move the world.” He was describing the physics of “leverage.”
Recently, The Wall Street Journal reported that “leveraged debt, part of the credit bubble” was making a comeback.
In finance, leverage is borrowed money. To the extent assets are controlled by borrowed money, that’s financial leverage. But furthermore, when the money that’s lent to a consumer also is borrowed, that creates debt upon debt – or leveraged debt. The credit bubble is made up of the multiple lenders that sit between the ultimate lender and ultimate borrower.
The term “leveraged buyout” (LBO) frequently is used in connection with acquisitions.
Companies buy control of another company (hopefully an asset) using borrowed funds. If the increase in value of the asset is greater than the cost of the borrowed funds, the leverage is positive and the acquiring entity’s return would be amplified.
For example, a manufacturing firm is considering purchasing a new machine for $250,000. The new machine will produce a new line of goods that the company believes will generate a profit of $75,000.
Without any borrowed money (leverage), the return on the cash purchase will be 30 percent. That is, a $75,000 profit divided by the $250,000 cash investment.
However, when the firm’s banker provides a $125,000 loan to finance 50 percent of the investment at an interest rate of 12 percent, the business now can purchase the machine with $125,000 cash and $125,000 debt.
The debt will cost $15,000 per annum in interest expense and will reduce the $75,000 profit to $60,000. However, dividing the profit of $60,000 by only $125,000 drives return on cash to 48 percent. (This example ignores the income-tax effect.)
Financial leverage is a powerful amplifier. Whatever you’re doing, profitable or not, financial leverage will magnify the result. If the leveraged asset produces less return than the cost of the borrowed funds, the firm’s losses will corkscrew downward at a head-spinning rate.
But there’s even more to consider. If the $125,000 that was loaned to the firm by the bank also was borrowed, the bank also is subject to the effects of leverage. On top of that, add two or three more lenders in the chain and you have layered leverage – a very risky position for all participants.
In a high-growth economy or industry, leverage generally is a good thing, particularly when the borrowed money is used to finance fixed assets (plant) or real estate, which will produce an unattended cash-flow stream.
This was the case in the cable television boom of the late 1970s and early ’80s, and in the housing market when it seemed that real estate values never would fall.
Unfortunately, entrepreneurs attempted to repeat this model in the telecommunications industry during the mid-to-late ’90s and in the real estate boom of the mid-2000s.
For a variety of reasons, the cash-flow stream didn’t materialize. Therefore, the borrowers who built the plant had highly amplified expense requirements. The result was the telecom implosion of 2000.
For the same underlying reason (too much layered leverage), the economic system collapsed in late 2008 as every decline in real estate value was amplified and rippled through the chain of multilayered leverage.
When analyzing a particular company for potential investment, the “debt ratio” (total debt divided by total assets) and the “debt-to-equity ratio” (total debt divided by equity) are important indicators of long-term solvency and risk.
Furthermore, the sophisticated investor now should look to the financial statements of the firm that’s providing the loans to the target investment. In other words, today’s investor must dig out the layered leverage. This involves peeling back several layers of the financial onion skin.
Another application of financial leverage is called “margin.” Most commonly used in stock market and futures trading, margin is the amount of money your broker will loan on a given purchase.
For example, many brokerage houses will loan 50 percent of the purchase price of a security. If the price of the security rises, this is good news for the investor. If not, the investor must provide even more cash to maintain the 50 percent ratio.
What’s the bottom line on financial leverage? If the underlying object of leverage performs well, so will you. If the value of the asset falls, the loss will be accelerated. Additionally, and maybe even more importantly today, the savvy investor will investigate further, looking for multilayered leverage.
© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.