Definition: Financial leverage, but additionally called trading on equity, would be that the monetary trade-off between the yield to the issuance of preferred share or debt and the price of keeping that preferred share or debt. To put it differently, can the business earn more out of their investment as it costs to keep the preferred share or debt?
What Does Financial Leverage Mean?
Companies can issue preferred shares and spend the cash bankers paid to your preferred share. Provided that the chosen returns are significantly less than the yield on the invested funds, the business is thought to possess financial leverage. Frequent investors shouldn’t be opposed to financial leverage because their ownership share stays similar while increasing shares.
Companies can sell preferred shares to the public for a certain cost. Let’s say Leverage, Inc. sells 1,000 stocks of preferred share for 1 dollar each. The company can then invest this $1,000 either in the share marketplace 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 share issuance because the cost of maintaining the share (the preferred share returns ) is less than the return on the capital received from the preferred shareholders.
Issuing preferred stocks is only one form of financial leverage. Companies can also issue debt, like bonds, to finance investments. The similarly financial leverage principle applies to debt just like the preferred share. 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 shares 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. This means that every dollar of shares or equity is matched by one dollar of debt.