Leveraged deals can financially benefit companies

On the Money
From the July 2, 2004 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.”

In finance, leverage is borrowed money. To the extent assets are controlled by borrowed money, that’s financial leverage.

Several years ago the term Leveraged Buyout, (“LBO”), was frequently used in connection with acquisitions. Companies would buy control of another company (hopefully an asset), using borrowed funds. If the leverage was positive, the increase in value of the asset would be greater than the cost of the borrowed funds 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 which the company believes will generate a profit of $75,000. If the firm has $250,000 of cash available, purchases the machine with the cash (100% equity, no leverage), the return on equity will be 30%. That is, a $75,000 return divided by the $250,000 cash investment.

Using financial leverage, the firm’s banker offers to provide a $125,000 loan to finance 50% of the investment at a rate of interest of 12%.

The business can now purchase the machine with $125,000 cash and $125,000 debt. The return on the total investment is unchanged (30%).

But now, return on the cash investment (because only $125,000 has been used, not $250,000) has increased by 18 percent to 48 percent.

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%. (This example ignores income tax effect.)

The return on equity has risen even when the company has replaced equity dollars originally earning a 30 percent return with relatively expensive debt dollars costing 12 percent.

Financial leverage is a powerful amplifier. But amplifiers themselves are rather stupid. They do only that-amplify. Whatever ever 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.

In a high growth economy or industry, leverage is generally a good thing; particularly when the borrowed money is used to finance fixed assets (plant), that will produce an unattended cash flow stream. This was the case in the cable television boom of the late 70’s and early 80’s.

Unfortunately and with too little foresight, entrepreneurs attempted to repeat this model in the telecommunications industry during the mid-to-late 90’s. For a variety of reasons, the cash flow stream did not materialize. Therefore the borrowers who built the plant had highly amplified expense requirements. The result was the telecom implosion of 2000.

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.

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. When positive financial leverage is in play this is good news for the investor.

However, using borrowed funds amplifies both gains and losses. You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased on margin may require you to provide additional funds to the firm that has made the loan.

Futures, such as gold contracts, and options are even more highly leveraged instruments requiring only a small amount of money, or margin. For example, to control a great deal of gold, the initial margin on a 100 ounce gold contract (with a value of approximately $39,000) is only $2,340. Interest expense on margin loans today is approximately 0.75 percent to 3 percent. But again, leverage cuts both ways.

After you have bought or sold a futures contract, the price of the contract can go either up or down. If you start to lose money on the position you have, then you will be required to post variation or maintenance margin. If this happens, a margin call will be made requesting (more like demanding) that you deposit additional funds to keep your account within certain prescribed limits.

What’s the bottom line on financial leverage? If the underlying object of leverage performs well, so will you. If the asset is fails, the loss will be accelerated.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.