What is Financial Leverage?: Risk and Debt Servicing Ability explained

Financial risk is the possibility of a company facing challenges that hinder its ability to meet financial obligations, leading to potential losses or even bankruptcy. One of the primary types of financial risk stems from the way a company manages leverage and its debt servicing ability. Understanding these two elements is crucial for investors, business owners, and analysts as they assess a company's financial health, risk exposure, and long-term sustainability.

In this guide, we’ll dive deep into financial risk, with a focus on leverage and debt servicing ability, explaining how these factors affect a company's financial stability and how businesses can manage them effectively.

1. Leverage: Using Debt to Fuel Growth

What is Leverage?
Leverage refers to the use of borrowed funds (debt) to finance investments or business activities. Essentially, leverage allows a company to amplify its potential returns, but it also increases its financial risk. Leverage is often measured using ratios that compare a company’s debt to its equity or assets.

Types of Leverage:

• Financial Leverage: The use of borrowed funds to finance a company's operations or investments, with the aim of increasing the potential return on equity.
• Operating Leverage: Refers to a company’s fixed costs relative to its variable costs. A company with high operating leverage has a larger proportion of fixed costs, which means that changes in sales can significantly impact profits.

Leverage Ratios:
Leverage ratios are used to assess the degree to which a company is using debt to finance its operations and investments. Common leverage ratios include:

1.1 Debt-to-Equity Ratio (D/E)

This ratio compares a company’s total debt to its shareholders' equity. It shows how much debt a company is using to finance its assets relative to equity.

• Formula:

Debt-to-Equity Ratio = Total Debt / Total Equity

Interpretation:

• A higher D/E ratio suggests higher leverage, meaning the company is relying more on debt to finance its operations. This increases financial risk but also offers the potential for higher returns.
• A lower D/E ratio indicates less reliance on debt and lower financial risk.

1.2 Debt-to-Assets Ratio

This ratio indicates what proportion of a company’s assets is financed through debt.

• Formula:

Debt-to-Assets Ratio=Total Debt / Total Assets

Interpretation:

• A higher ratio suggests that a large portion of the company’s assets is financed by debt, which can increase financial risk if cash flows aren’t sufficient to cover the debt.

1.3 Interest Coverage Ratio

The interest coverage ratio measures a company's ability to meet its interest payments on outstanding debt. It’s a key indicator of the company’s debt servicing ability.

• Formula:

Interest Coverage Ratio = EBIT / Interest Expense 

Earnings Before Interest and Taxes.

• Interpretation:

  • A higher ratio indicates that the company can comfortably cover its interest expenses from its operating profits.
  • A ratio below 1 suggests that the company may not generate enough income to cover its interest payments, leading to a risk of default.

Impact of Leverage on Financial Risk:

• Higher Leverage: While using more debt can help a company amplify returns, it also increases financial risk. In case of poor performance or economic downturns, the company may struggle to meet its interest and principal repayment obligations.
• Lower Leverage: A company with less debt is less vulnerable to interest rate fluctuations and economic downturns. However, it may also miss out on growth opportunities that could be financed with borrowed funds.

Example:

• Tesla (a high-growth company) might use leverage to fund its expansion into new markets or invest in new technology. This can accelerate growth, but high levels of debt increase financial risk in case revenue growth doesn’t meet expectations.
• In contrast, Coca-Cola, a mature company, might have lower leverage, as its steady cash flows and low debt make it less risky but also less flexible in terms of rapid expansion.

2. Debt Servicing Ability: Managing Debt Obligations

What is Debt Servicing Ability?
Debt servicing ability refers to a company’s ability to meet its debt obligations, including both principal repayments and interest payments. Debt servicing is a critical aspect of financial health because failing to manage debt can lead to financial distress, credit downgrades, or even bankruptcy.

Key components of debt servicing ability include:

• Interest payments: The periodic payments made on the borrowed funds.
• Principal repayments: The repayment of the borrowed principal amount.

Factors Affecting Debt Servicing Ability:

• Cash Flow: The company’s ability to generate sufficient cash flow from its operations to cover debt payments.
• Profitability: The company’s ability to generate profits to cover debt expenses.
• Liquidity: The company’s access to liquid assets or short-term financing options to cover debt obligations.

2.1 Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is one of the key ratios used to measure a company’s debt servicing ability. It indicates whether a company generates enough cash flow to meet its debt obligations.

• Formula:

DSCR = Operating Income / Total Debt Service 

Where Total Debt Service includes both principal and interest payments.

• Interpretation:

  • A DSCR greater than 1 means the company generates enough income to cover its debt payments.
  • A DSCR less than 1 suggests that the company does not generate enough income to cover its debt obligations, potentially leading to financial distress.

Example:

• A company with an operating income of INR 5 crore and debt service requirements of INR 4 crore would have a DSCR of 1.25 (5/4), indicating that it can comfortably meet its debt obligations.

2.2 Cash Flow to Debt Ratio

This ratio measures the company’s ability to pay off its total debt with its operational cash flow. It is a measure of liquidity and debt servicing capability.

• Formula:

Cash Flow to Debt Ratio= Operating Cash Flow / Total Debt

Interpretation:

• A higher ratio indicates that the company generates ample cash flow to service its debt.
• A lower ratio suggests that the company may struggle to meet its debt obligations and could face liquidity issues.

3. Managing Financial Risk: Strategies for Mitigation

3.1 Risk Diversification

• Diversifying revenue streams and debt sources can help spread risk. For instance, businesses can reduce their reliance on debt by generating equity capital or investing in diverse products, markets, and geographies.

3.2 Debt Restructuring

• Companies facing difficulty in debt servicing may negotiate with creditors to restructure their debt terms, extending repayment periods or reducing interest rates to make debt obligations more manageable.

3.3 Reducing Operational Costs

• Companies can improve their debt servicing ability by increasing their profitability through cost-cutting measures, increasing operational efficiency, or enhancing productivity.

3.4 Hedging Interest Rate Risk

• Companies with floating-rate debt may hedge interest rate risk through interest rate swaps or other financial instruments to lock in a stable rate and reduce exposure to rising interest rates.

3.5 Increasing Cash Flow

• Strengthening cash flow generation is crucial for debt servicing. Companies can focus on increasing sales, optimizing inventory management, or improving working capital cycles to generate more cash.

Happy Investing!