What is Overleveraged? How Does it Affect Our Finances?
In the world of finance, ‘leverage’ means a sum of borrowed money. To be ‘overleveraged’ means to have too much debt. Specifically, businesses/individuals are said to be overleveraged if they carry a large amount of debt and hence cannot pay their outstanding loans. The formula for financial leverage is:
Financial Leverage=Operating Income/Net Income
Therefore, a company is said to be overleveraged if its running expenses overshadow its income, and it cannot pay interest on its various debts. An overleveraged company runs the risk of bankruptcy if their sales falter or their profits drop. A company which is not overly leveraged is better equipped to handle drops in profits.
What is Leverage?
Leverage is the use of various financial tools and or borrowed capital to increase the amount of potential return. A company or an individual is said to be overleveraged if the debts are greater than equity, where equity is defined as the value of assets minus the liabilities on said assets.
Companies use leverage to finance their operations and to try and increase their net profits. By using debt financing, a company has a far greater sum to invest in business operations than it would have had previously.
Leveraging in Personal Financing
Leveraging allows the multiplication of your profits or your losses. It runs the risk of incurring a loss, when the costs exceed the income from an asset, or when the value of said asset reduces.
There are several sources of leveraging, such as:
- Many people leverage their savings while purchasing homes by financing a portion of their purchase using mortgage debt.
- Individuals often borrow from investment brokers while investing in a market.
- Owners of businesses leverage their finances by borrowing money which they need to run their businesses.
While leveraging is a sure shot way of boosting profits, it can also incur heavy losses. This can happen when the market has little liquidity and sales start reducing prices. In such a case, leverage increases as the losses keep piling up. This can lead to the demise of a business or the ruin of a firm or individual, even if the decline in asset value is not heavy and it is temporary. The other extreme, of leveraging in the forex markets, has relatively lower risk thanks to a stable market. Many brokers allow their customers to control a higher value of money than they initially deposit. For example, some brokers allow their customers to use money in a ratio of 100:1 to their original investment, as long as the customer takes full responsibility for the profits or losses on this amount.
Disadvantages of being Overleveraged
Leveraged finance has its perks but it comes with a higher-than-normal amount of debt which could increase your exposure to financial risk. It is also more costly as high yield bonds and leveraged loans pay higher interest rates as compensation for taking in greater risks.
Leveraging and India Inc
Corporate debt has grown at a very fast pace in the past decade in our country, and it is only 1.6 times lesser than the debts of the Union government today. This outstanding debt is now equal to more than a third of India’s GDP (34 percent in 2013-14). According to the CEO of India Ratings, Atul Joshi,“most of the Indian companies have rating downgrades in the recent past due to overleveraging.” This is why overleveraging is a top concern for Indian firms.
An example of this principle is “house flipping”. “A house flipper” will buy a house, renovate it (using borrowed money or not) and then sell it for a greater price. Dave Ramsey points out, “If you want to win with money, you need to take “payment plans” out of your vocabulary. Successful people don’t finance their couches. Or their dining room tables. Or even their cars. If you have to put it on a payment plan, you can’t afford it. As the old saying goes, “Broke people ask, ‘How much per month?’ and rich people ask, ‘How much?’” The main factor for getting rich is to understand how you can use someone else’s money for yourself, whether it’s by borrowing or by utilising investment capital. Hence, leveraging is key to a richer you.
Is financial leverage good or bad?
Leverage is not either inherently good or bad. It expands the positive or negative effects of income generation and productivity of the assets in which we invest. In order to determine the effects of financial leverage, one should be aware of its potential impact and volatility.
It is preferred to use leverage within one’s risk parameters, in line with one’s financial goals. As is highlighted in the principle of ways and means, leveraging is the way to boost your means, which in turn can be used to generate a greater profit. Every company uses leverage as part of its financial strategy. Very often, people tend to think only about the left side of their balance sheet and forget right side. Thinking more like a corporate magnate and employing leverage in strategic ways can help individual investors swell their profits. Along with investments and wealth planning, credit and leveraging is just another bullet in the barrel for the savvy investor.