Understanding the importance and implications of Leverage

Importance of Leverage

Leverage increases the volatility of a company's earnings and cash flows, thereby increasing the risk borne by investors in the company.

The more significant the use of leverage by the company, the more risk it is and therefore, the higher the discount rate that must be used to value the company.

A company that is highly leveraged, risks significant losses during economic downturns.



Leveraged is affected by a company's cost structure.

Generally companies incur two types of costs:

• Variable costs: vary with the level of production and sales (e.g., raw materials costs and sales commissions).
• Fixed costs:  remain the same irrespective of the level of production and sales (e.g., depreciation and interest expense).

Conclusion:

The higher the proportion of fixed costs (both operating and financial) in a company's cost structure (higher leverage) the greater the company's earnings volatility.

The greater the degree of leverage for a company, the steeper the slope of the line representing net income.