Chapter 13
Leveraging and Debt – Can it be a Smart Move?
In simple terms, leveraging is borrowing to invest, in the hopes that the investment will generate a higher rate of return than the interest rate of the debt. The investment that is financed by debt may be intended to increase a company’s corporate wealth by expanding its market share, or adding new product lines to increase net income. It can also involve investing in other companies’ shares to enhance a special relationship or receive share dividends and capital appreciation of the shares as a return on investment. No matter the reason, there are important aspects of leveraging that must be considered before entering into such an arrangement.
- Does the company currently generate enough net income and hold enough assets to service the proposed leveraging strategy?
- Is leveraging the best strategy, given alternative financing arrangements such as increasing equity by issuing more shares?
- Does management clearly understand the risks of taking on a leveraging strategy or is the decision driven more by emotions than by careful consideration?
- Since leveraging increases the debt burden, will this impact any existing restrictive debt covenants from other creditors?
- Does the company have sufficient business processes in place to adequately monitor and measure the return of the investment funded by the additional debt? This must be done to ensure that the return from the investment exceeds the interest rate of the debt itself.
- If the investment’s return is less than expected, does the company have enough net income and other resources to keep the investment in hopes of an improvement in the future?
- Is the company diversified enough to achieve a balance between the leveraged investment and its other sources of funds and operations?
(Source: HSBC, 2013)
