What is the meaning of ''being a highly leveraged company''?

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Leverage is a common technique employed by companies as well as investors in the world of finance to multiply their gains or returns on their asset portfolio. The process does not ensures success and indeed the probability of incurring huge losses is multiplied several times in highly leveraged situations. So the question that arises is what actually does highly leveraged position imply?

Financial institutions, banks and companies generally finance their operations through two sources, own capital base or equity and borrowed capital or credit. In a case, when the borrowed assets are higher than one's own capital base or assets, an entity is said to be 'highly leveraged'.

Simple illustration of 'highly leveraged' position: Suppose if an institution purchases some asset using its own capital then it is not leveraged. However, if the same entity buys some equipment with 80% credit and 20% own capital, it is in a highly leveraged position. And further borrowing of funds by the entity would render it in a massively leverage position.

As per investment experts, leveraged companies are by far more volatile in comparison to self-financed companies. Profits by such companies could be reaped only in a situation when their earnings exceed the debt amount which they are obliged to pay-off to their creditors.

Leverage in a general scenario stimulates economic activity and bolsters investments. However, there is a downside to leverage as there is always an element of risk associated with future returns from investments. And in a case when future earnings do not turn out to be in line with the expected returns, companies and investors can even turn bankrupt. Hence, banks and other financial institutions do not entertain financing to highly leveraged entities and individuals.


Read more about: debt, equity, leverage, roi
Story first published: Thursday, September 12, 2013, 11:34 [IST]
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