Definition: Financial leverage, also called trading on equity, is the financial trade off between the return on the issuance of preferred stock or debt and the cost of maintaining that preferred stock or debt. In other words, can the company earn more from their investment than it costs to maintain the preferred stock or debt?
What Does Financial Leverage Mean?
Companies can issue preferred stock and invest the money shareholders paid for the preferred stock. As long as the preferred dividends are less than the return on the invested capital, the company is said to have financial leverage. Common shareholders shouldn’t be opposed to financial leverage because their ownership share stays the same while increasing assets.
Example
Companies can sell preferred stock to the public for a certain price. Let’s say Leverage, Inc. sells 1,000 shares of preferred stock for 1 dollar each. The company can then invest this $1,000 either in the stock market or in new capital for the business operations. Let’s assume the $1,000 was reinvested at a rate of 10 percent. At the end of the year, the company issues a 5-cent dividend to each preferred shareholder.
Leverage, Inc. is financially leveraging its preferred stock issuance because the cost of maintaining the stock (the preferred stock dividends) is less than the return on the capital received from the preferred shareholders.
Issuing preferred shares is only one form of financial leverage. Companies can also issue debt, like bonds, to finance investments. The same financial leverage principle applies the to debt just like preferred stock. As long as the return on investments is greater than the interest paid on the issued bonds, the company will have effectively leveraged their finances.
The term financial leverage is also used to describe the overall debt load of a company by comparing debt to assets or debt to equity. In a sense, it’s a measure of how risky the company is. A highly leveraged company would have a leverage ratio close to 1 or higher. These means that every dollar of assets or equity is matched by one dollar of debt.
