Financial leverage increases the potential reward to shareholders but it also increases the potential for financial distress and business failure.
Debt increases the risk of the firm and at the same chances for potential higher returns may increase. The increase in returns is the result of the lower cost of capital as a result of the interjection of debt in the capital structure of the company. Thanks.
I agree with you. Debt in WO position is not bad and the position ST could be bad. Ofcourse that the debt in position of WT is a very heavy overload for any organization. I summarize that the states including "WT" and "ST" is not favorable for the debt while it is suitable for the the states "SO" and "WO". Finally we should know our position in the SWOT matrix.
An increase of debt is likely to improve earnings/return on equity for shareholders, despite the arguments that low-cost debt may enhance investment returns (Ghosh and Moon, 2010; Anderson 2017); however, a highly geared business implies that the business/company, which has to be more dependent on debt, is more risky. Here, a rule of thumb is that a highly geared business/company has to be justified by reliable/healthy cash flows (Holliwell, 1997; Hale, 1983; Ghosh and Moon, 2010).
- Anderson, T. J. (2017). The Value of Debt in Building Wealth, Hoboken, New Jersey, John Wiley & Sons, Inc.
- Ghosh, A. A. and Moon, D. (2010). Corporate debt financing and earnings quality. Journal of Business Finance and Accounting, 37, 5-6, pp. 538-559.
- Hale, R., H (1983). Credit Analysis: A Complete Guide, New York, John Wiley & Sons, Inc.
- Holliwell, J. (1997). The Financial Risk Manual: A Systematic Guide to Identifying and Managing Financial Risk, London, Pitman Publishing.
The following sources are also helpful for your topic:
- Berman, K. and Knight, j. (2009). When is debt good? Harvard Business Review, Available from: https://hbr.org/2009/07/when-is-debt-good.
- Durden, T. and Tenebrarum, P. (2016). The Problem With Corporate Debt. Zero-hedge, Available from: http://www.zerohedge.com/news/2016-06-19/problem-corporate-debt.
- Piper, T. R. and Weinhold, W. A. (1982). How much debt is right for your company? Harvard Business Review, 60, 4, pp. 106-114.
Basically, if you can use somebody's money to make money for yourself, then you are simply wise. This is why debt funding could be a better option than equity funding. In practice, however, it is difficult to secure capital which is 100% loan. Anybody giving a loan to somebody to do business would normally want to know what percenage of the total capital is equity. The IRR of the business must be higher than the cost of capital before the business can be declared profitable. If you can secure a higher percentage of the total capital as a loan with a very low interest rate so that the business becomes very profitable, the share holders would be very happy.
I like to use the physics analogy of the lever. By placing the lever at the right point on the fulcrum, you can improve performance by lifting a heavy load more easily. Thet rick is to find the optimal point for the lever (like using different gears in a machine like a bicycle - gearing to boost performance).
The whole concept of financial leverage is actually surrounded by confusion in the literature. There is no universal definition of it, and there are many different metrics relating to leverage. Sometimes leverage simply means debt (or a ratio of debt to capital, assets, etc.), sometimes it's the effect of debt, sometimes the risk, etc. A good overview is this paper by T. Berent: http://www.wneiz.pl/nauka_wneiz/frfu/66-2014/FRFU-66-255.pdf
In fact, the author wrote an entire monograph on the theory of financial leverage, but it's available only in Polish at this time. It is a very good piece of original research (in fact, revolutionary in some aspects). You may get a glimpse into some of the problems by studying these two papers by Berent:
http://kolegia.sgh.waw.pl/pl/KGS/struktura/KRK/Documents/Ekonomista2013_Berent.pdf
http://www.wneiz.pl/nauka_wneiz/frfu/38-2011/FRFU-38-329.pdf
I personally view financial leverage as the financial analogue of mechanical advantage, also called leverage in classical mechanics. Such model allows for a straightforward translation of the tools from analytical mechanics to financial economics but, suprisingly, it appears that there is no research done in this direction.
As pointed out above debt can be both positive and negative. At a personal level I have used debt to advantage through buying a small number of assets where asset return > cost of debt.
If you would like an example of extreme debt to help delineate the potentially catastrophic consequences of leverage, you might like to read Long-Term Capital Management. An interesting and instructive case. You will easily find material on this via Google. Probably the main reference is:
Lowenstein, 'When genius failed: The rise and fall of Long-Term Capital Management', Random House, Oct 2000
I also did a review of Long-Term Capital Management's use of debt as part of my doctoral thesis on page 73 of the attached.
Thesis An analytical tool to aid the reflective selection of equity...
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