Leverage is the term which is used in the context of finance and it refers to that process where a company takes debt and uses it in the business so as to make profits. The idea behind taking leverage is that rate of profit will be much higher than the cost of debt and due to this company will be able to make more profits with leverage than without leverage. In order to understand this concept let’s look at some of the advantages and disadvantages of leverage –
Advantages of Leverage
- The biggest advantage of leverage is that it helps in increasing the liquidity available to the company because when company takes loan or debt it receives cash from the lender and that cash can be used by the company for variety of activities like purchasing new machinery or building which will help in increasing the efficiency of the company or company can use the cash for buying other companies which will increase in scale of operations of the company and so on.
- Another benefit of leverage is that in the case of growing companies which needs cash for its activities use of debt can result in multiplication of the profits for the company as the cost of debt is somewhere between 8 to 15 percent while rate of profits in case of growing companies can range from 20 percent to 100 percent. Hence as long as the company is growing leverage tends to magnify the profits of the company.
- Another advantage of leverage is that companies which do not want to dilute their ownership this route of financing is good because in case of debt financing or loan company has to repay the principal amount on maturity along with periodical interest and there is no risk of giving equity to anybody resulting in complete control of the company by the owners of the company.
Disadvantages of Leverage
- The biggest disadvantage of leverage is that there is a risk that company uses too much leverage which in turn can lead to problems for the company as beyond an optimum level of leverage there will no benefit of taking leverage. Hence companies which are earning normal or below average profits leverage can do more harm than good.
- Another limitation of leverage is that due to leverage company may make decisions which it would not have made if there was leverage. So for example a company sitting on cash due to leverage may acquire loss-making company or purchase assets even when they are not required. In short, it can result in company making irrational decisions which can haunt company for many years
- Since leverage mean paying regular interest payment without any delay it puts an obligation on the company to pay interest no matter what the financial position of the company is and in worst case scenario it can even lead to the bankruptcy of the company.
As one can see from the above that leverage is a double edged sword as it has benefits as well as limitations and any company thinking of taking leverage should carefully analyze above points and then take the decision accordingly.