Financial leverage is a term used frequently in M&A, commercial banking, and in the finance industry in general. It’s an important concept to understand for business owners and finance professionals alike. This guide will explain what financial leverage is and why it is used.
Investors and corporations use debt (leverage) to increase their buying power in the market.
A company uses financial leverage to acquire assets sooner, to have to spend less cash up-front to acquire them, and because they expect the capital gains or the additional income from the new asset acquired will make them more money than the cost of borrowing the money to finance the purchase.
The objective of using financial leverage is to increase the investor’s profit without having to pay for the asset/deal entirely with their cash.
The use of leverage allows companies and investors the ability to buy more expensive assets and to do larger M&A deals.
Companies can generally pay for assets in four ways. They can use equity (ownership stake), debt (leverage), they can pay for the assets with cash, or they can lease them. In accounting, technically cash is a form of equity, but we’ll single it out here because cash reserves are necessary in business and equity financing (giving stock/ownership) doesn’t have the effect of reducing cash.
Equity generally carries the highest cost of all of these four ways to pay for assets. In order to pay for assets with equity, you would need to give partial ownership of your company in return.
The use of cash can also carry a high cost—and can be risky. Cash is the life blood of a business. Without positive cash flow, the business will fail. While paying for small, inexpensive assets with cash is generally the “best” idea, purchasing larger assets with a lump sum of cash can be risky. If your business has $500,000 in cash and needs to buy equipment that costs $450,000 this reduces cash by 90 percent. This may be a risky decision for the business. They may get into trouble if they have a few bad months or the economic climate changes.
The other alternative to debt is leasing the asset. A lease is an agreement where the lessor (owner) promises the lessee (borrower) use of the asset for an agreed upon length of time while the lessor gets consistent payments over the period of the lease. Under IFRS accounting all leases are categorized as “finance leases,” and under US GAAP, leases can be categorized as either “finance” or “operating” leases, depending on how they are structured.
Leases may be a good alternative to using traditional debt (ie. term loans) to finance a transaction. However, this may or may not make sense, and leasing may or may not be available given the type of transaction the company is looking to make. It’s unlikely that a competitor would lease you their business for five years for example. They would try and sell the business and you would have to use debt or equity to buy it.
Debt on the other hand comes at no reduction in equity and requires a comparatively small up-front cash expenditure compared to buying the asset outright.
These are large considerations for deciding whether or not to use financial leverage to purchase an asset.
In M&A transactions, companies often use leverage to acquire other businesses.
There are two general categories of buyers in M&A—financial and strategic buyers. Financial buyers are typically non-operators that look to purchase businesses and sell them later down the road for a profit. Strategic buyers are typically other companies (often in the same industry) that are looking to buy competitors, create financial synergy, or for vertical or horizontal integration. (See links below for more information on these subjects.)
Both types of buyers—financial and strategic—use leverage in their acquisitions.
The use of financial leverage to acquire another business is called a leveraged buyout (LBO). While both types of buyers use leverage in M&A deals, financial buyers typically use the most—up to 70 or 80 percent of the purchase price funded with debt.
As an example: If Company A buys Company B for $100m, and $35m is paid for in cash (or stock), and they borrow $65m to pay the rest, then they have used 65 percent leverage in the deal.
Both types of buyers use leverage to buy companies in M&A because the purchase price to acquire these businesses is so high. Financial leverage allows them to acquire assets they otherwise wouldn’t be able to buy.