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Financial leveraging is the lift taking companies up or down
Kenya Breweries Limited Managing Director Jane Karuku at the EABL plant in Ruaraka, Nairobi. Her’s is one firm that has opted for the corporate bond route successfully.
The Covid-19 menace and efforts to curb its spread, caused an unparalleled blow to the cash flows of businesses thereby resulting in the need for external financing. How did corporate leverage respond? What does the impact on leverage mean for financial stability? Now that global economies are emerging from the pandemic, businesses are aggressively planning for growth via leveraging.
Financial leverage simply means the presence of debt in the capital structure of a firm. This could be existence of fixed interest-bearing capital, which may include preference share capital, corporate bonds along with debentures, and so forth. Many private companies and listed entities on the Nairobi Securities Exchange have issued corporate bonds. For instance, the East Africa Breweries Limited corporate bonds have recently been oversubscribed.
The objective of introducing leverage to capital is to achieve the maximisation of the wealth of the shareholders. Financial leverage deals with profit maximisation magnification. The concept of financial leverage is not just important to business but it is equally crucial for individuals as well.
Financial planning
Debt is an integral part of financial planning for anybody, whether it is an individual or a company. In a firm, it is required not only on the grounds of need for capital but also to enlarge the profits accruing to shareholders.
The argument used by the financial officers of organisations when leveraging is that the introduction of debt in the capital structure will not have an impact on the sales and operating profits. It will also assist in the return on equity percentage. Financial leverage indicates the reliability of a business on its debts in order to operate.
It is important for an organisation to know the extent of its financial dependency on borrowing and solvency. Many well-known businesses across Kenya have been in the headlines over the past months for insolvency and being placed under administration.
It is advisable for investors/shareholders and all stakeholders to be aware of the financial leverage of businesses as it helps investors know the creditability of the company and the risk involved in terms of a monetary transaction.
Debt
In order to know the financial leverage of a company, compute the total debt owed by the firm (short and long-term including commodities such as mortgages), and estimate the total equity held by shareholders. Divide total debt by the total equity. This is the financial leverage ratio.
Knowing about the method and technique of calculating financial leverage can help determine an individual or business’ financial solvency and dependence upon borrowings.
The key steps to follow in the calculation of financial leverage include the following; compute total debt owed by the company (short as well as long term debt) also including commodities such as mortgages and money due for services provided.
Thereafter, estimate the total equity held by shareholders in the company. This requires multiplying the total outstanding shares by the stock price. The total amount obtained represents the shareholder equity. Divide the total debt by total equity, the quotient total thus obtained is the financial leverage ratio.
A ratio higher than 2:1 indicates financial weakness. If the company is leveraged highly it is considered to be near bankruptcy. A highly leveraged company may not be able to secure new capital and may not be capable of meeting current obligations.
Too much leverage can be bad, but there is no hard and fast rule as to how much is too much. No matter what its use, leverage can be a powerful tool when used responsibly. Investors and companies use leverage to expand, hedge, and speculate but companies that are overly aggressive with leveraging can easily go into bankruptcy.
One of the most important evaluations of a company’s leverage is the debt to equity ratio. The interest coverage ratio/times interest earned is a measure of how well a company can meet interest payment obligations. In general, these ratios indicate whether a company is too safe and neglecting opportunities to magnify earnings through leverage or is over leveraged and at serious risk of default or bankruptcy.
Capital structure
Financial leverage is the degree to, which a company uses fixed-income securities such as debt and preferred equities. The more debt a company uses the higher its financial leverage is. A high degree of financial leverage means high-interest payments, which negatively affect the company’s bottom line earning per share.
Whilst financial risk is the risk to the stockholders that is caused by the increase in debt and preferred equities in a company’s capital structure. As a company increases debt and preferred equities, the interest payment increases, thereby reducing earnings per share.
President Uhuru Kenyatta on Wednesday 20th October ordered lenders to stop listing defaulters of Sh5 million and below on Credit Reference Bureaus (CRBs) to allow them to access loans. Additionally, banks and financial institutions have been ordered to restructure loans.
A similar moratorium was offered between April and September 2020. Due to the increased risk of defaults during the last such moratorium, as Kenyans no longer feared being listed as defaulters, institutions reduced lending to risky customers, dealing a huge setback to borrowers.
Shareholders of banking institutions continue to hope that management will ensure all safety measures before issuing loans. Defaults on payment of loans affect the profitability of firms causing a spiral effect to all stakeholders.
