Firms’ use of long-term finance: why, how, and what to do about it?
The first part of Chapter 2 of the 2015 Global Financial Development Report examines the use of long-term finance from the firm’s perspective. It draws on theoretical and empirical studies to ask why firms would want to use long-term finance and how this use affects their performance. It also relies on the most recent data and evidence to show how use of long-term finance varies across countries and discusses what governments can do to promote the use of long-term finance by firms. Here are the main messages regarding firms’ use of long-term finance:
Firms tend to match the maturity of their assets and liabilities, and thus they often use long-term debt to make long-term investments, such as purchases of fixed assets or equipment. Long-term finance also offers protection from credit supply shocks and having to refinance in bad times. But not all firms need long-term finance. For example, firms with good growth opportunities may prefer short-term debt since they may want to refinance their debt frequently to obtain better loan terms after they have experienced a positive shock.
The theoretical literature is inconclusive on how the maturity of debt affects investment and firm performance. On the one hand, long-term finance is likely to have a positive effect on investment and performance for firms that need it since it allows firms to invest in projects that bring in returns in a relatively long time horizon. On the other hand, long-term finance can distort managers’ incentives, hampering investment and firm performance. However, empirical evidence from both cross-country and within country studies suggests that long-term finance has a positive effect on firm investment and performance—unless the finance is provided in the form of directed credit.
Information on the use of long-term finance by firms across a large number of countries comes primarily from balance sheet data collected from Bureau Van Dijk in the ORBIS database and also from the World Bank’s Enterprise Surveys. Both data sources suggest that firms in developing countries have fewer long-term liabilities than firms in high-income countries, even after controlling for firm characteristics (see Figure 1 below). Also, small firms use less long-term finance than larger firms.
Source: ORBIS data for 87 countries, covering the period 2004 to 2011. For a detailed data description, see Demirgüç-Kunt, Martinez Peria, and Tressel (2015a).
Note: Developing countries include low- and middle-income countries. Firm size is defined based on number of employees.
A stable political and macroeconomic environment is a necessary condition for long-term finance to thrive since it allows firms to predict the risks and returns associated with long-term investments. Also, firms’ ability to obtain long-term financing tends to be greater in countries with a contestable, well-regulated banking system and with developed capital markets.
Weakness in the contractual environment is an important underlying reason why long-term debt is less common in developing countries. When lenders cannot rely on legal institutions to enforce their claims to loan repayment, they may prefer to lend short term, so that the continued need for renegotiation provides incentives for borrowers to exert effort and make sound investments. In fact, most policies that can increase the supply of long-term finance are based on interventions that lessen the need to rely on short-term debt to discipline and monitor firms.
- Quick contract enforcement through specialized debt recovery courts, in particular, has been shown to increase firms’ debt maturity. Other legal institutions that help lenders enforce their claims include creditor rights and bankruptcy laws.
- An effective corporate governance framework can lessen firms’ reliance on short-term debt. Corporate governance matters for loan maturity because monitoring firm managers through independent boards and stronger shareholder protections can substitute for monitoring through the use of short-term debt.
- Information sharing through credit bureaus fosters long-term finance by reducing information asymmetries between firms and lenders.
- The introduction of registries for movable assets is also associated with an increase in the maturity of bank loans to firms since these registries increase the amount of assets that firms can post as collateral.
- Leasing arrangements allow firms to use and eventually own fixed assets and equipment. While leasing tends to be more prevalent in strong institutional environments, countries that do not have strong contract laws can still develop a leasing market if they pass appropriate leasing legislation.
Financial Leverage Analysis: How to Use Debt Wisely and Avoid Over Leveraging
1. What is Financial Leverage and Why Does It Matter?
Financial leverage refers to the use of borrowed funds or debt to finance investments or business operations. It is an important concept in the field of finance as it can have a significant impact on the profitability and risk profile of an organization.
From the perspective of companies, financial leverage allows them to amplify their returns on investment. By using debt to finance projects or acquisitions, companies can benefit from the potential upside of these investments without having to commit a large amount of their own capital. This can lead to higher returns for shareholders if the investments are successful.
However, financial leverage also introduces additional risks. When a company takes on debt, it becomes obligated to make regular interest payments and repay the principal amount at maturity. If the company is unable to generate sufficient cash flows to meet these obligations, it may face financial distress or even bankruptcy.
From an investor’s point of view, financial leverage can magnify both gains and losses. When an investor buys shares of a leveraged company, they are essentially buying a claim on the company’s assets and future cash flows. If the company performs well, the investor stands to benefit from the increased value of their shares. However, if the company’s performance deteriorates, the investor may experience significant losses.
To provide a more in-depth understanding of financial leverage, let’s explore some key points:
1. debt-to-Equity ratio: This ratio measures the proportion of a company’s financing that comes from debt compared to equity. A higher debt-to-equity ratio indicates a higher level of financial leverage.
2. interest Coverage ratio: This ratio assesses a company’s ability to meet its interest payments. A higher interest coverage ratio indicates a lower risk of defaulting on debt obligations.
3. Leverage and Risk: While financial leverage can enhance returns, it also increases the riskiness of an investment. Investors should carefully assess the risk-return tradeoff before investing in leveraged companies.
4. Leverage and cost of capital: The cost of capital for a company is influenced by its capital structure. Higher levels of debt can lead to higher borrowing costs and increased financial risk.
5. Leverage and Tax Benefits: interest payments on debt are tax-deductible, which can provide tax advantages for leveraged companies. This can result in lower overall tax liabilities and increased cash flows.
It’s important to note that the examples and insights provided here are based on general knowledge and understanding of financial leverage. For specific and accurate information, it is always recommended to consult reliable sources or seek professional advice.
What is Financial Leverage and Why Does It Matter – Financial Leverage Analysis: How to Use Debt Wisely and Avoid Over Leveraging
2. The Benefits of Using Debt to Finance Your Business or Investments
Debt is often seen as a negative word in the world of finance, but it can also be a powerful tool to grow your business or investments. Debt allows you to borrow money from others and use it to fund your projects, assets, or operations. By using debt, you can leverage your existing capital and increase your potential returns. However, debt also comes with risks and costs, such as interest payments, repayment obligations, and the possibility of default. Therefore, it is important to use debt wisely and avoid over-leveraging, which means borrowing more than you can afford to repay. In this section, we will explore the benefits of using debt to finance your business or investments, and how to balance them with the drawbacks.
Some of the benefits of using debt are:
1. Access to more capital. Debt can help you access more funds than you have available from your own sources, such as savings, equity, or retained earnings. This can enable you to pursue larger or more profitable opportunities, such as expanding your business, acquiring new assets, or investing in new markets. For example, if you have $100,000 of your own capital and you borrow another $100,000 at 10% interest, you can invest $200,000 in a project that yields 15% return. Your net profit would be $10,000, which is higher than the $7,500 you would earn if you only used your own capital.
2. Tax benefits. Debt can also provide tax benefits, as the interest payments on debt are usually deductible from your taxable income. This can lower your effective tax rate and increase your after-tax cash flow. For example, if you have a taxable income of $100,000 and you pay $10,000 in interest on your debt, your taxable income would be reduced to $90,000. Assuming a 25% tax rate, your tax liability would be $22,500, which is lower than the $25,000 you would pay without debt. Your after-tax income would be $67,500, which is higher than the $65,000 you would earn without debt.
3. Control over your business or investments. Debt can also give you more control over your business or investments, as you do not have to share ownership or decision-making power with other parties, such as equity investors or partners. By using debt, you can retain full ownership and authority over your assets and operations, and benefit from the full upside of your success. For example, if you use debt to finance your business, you do not have to dilute your equity or give up any voting rights to your creditors. You can also decide how to allocate your profits and reinvest them in your business. However, you also have to bear the full downside of your failure, and face the consequences of defaulting on your debt.
The Benefits of Using Debt to Finance Your Business or Investments – Financial Leverage Analysis: How to Use Debt Wisely and Avoid Over Leveraging
3. The Risks of Over-Leveraging and How to Avoid Them
Leverage is a powerful tool that can help you amplify your returns and achieve your financial goals faster. However, leverage also comes with significant risks that can wipe out your capital and put you in debt. Over-leveraging is a common mistake that many investors and businesses make, especially when they are overconfident or greedy. In this section, we will explore the risks of over-leveraging and how to avoid them.
Some of the risks of over-leveraging are:
1. margin calls and liquidation. When you use leverage, you are borrowing money from a broker or a lender to invest in an asset. This means that you have to maintain a certain level of equity or collateral in your account, otherwise you will face a margin call. A margin call is a demand from the broker or the lender to deposit more money or sell some of your assets to cover the shortfall. If you fail to meet the margin call, your broker or lender can liquidate your assets at a loss, leaving you with little or no money left.
2. Interest and fees. Leverage is not free. You have to pay interest and fees to the broker or the lender for using their money. These costs can eat into your profits and increase your losses. For example, if you borrow $10,000 at 10% interest per year to invest in a stock that returns 15% per year, your net return is only 5% ($1,500 – $1,000). However, if the stock drops by 10%, your net loss is 20% (-$1,000 – $1,000).
3. volatility and market risk. Leverage magnifies both your gains and losses. This means that you are more exposed to the volatility and market risk of the asset you are investing in. A small price movement can have a big impact on your account balance. For example, if you invest $10,000 in a stock with 2x leverage, you are effectively controlling $20,000 worth of the stock. If the stock goes up by 10%, you make $2,000, which is a 20% return on your investment. However, if the stock goes down by 10%, you lose $2,000, which is a 20% loss on your investment.
4. Emotional stress and psychological pressure. Leverage can also affect your mental and emotional well-being. When you use leverage, you are taking on more risk and uncertainty. This can cause you to experience stress, anxiety, fear, greed, overconfidence, or panic. These emotions can cloud your judgment and lead you to make poor decisions. For example, you may hold on to a losing position for too long, hoping for a reversal, or you may sell a winning position too soon, fearing a reversal.
To avoid the risks of over-leveraging, you should follow these tips:
– Use leverage sparingly and wisely. Leverage is not a magic bullet that can guarantee you high returns. It is a double-edged sword that can cut both ways. You should only use leverage when you have a clear and rational reason to do so, and when you have done your homework and analysis. You should also use leverage within your risk tolerance and financial capacity. Do not borrow more than you can afford to lose, and do not risk more than you are willing to lose.
– Have a risk management plan. Before you enter any leveraged position, you should have a risk management plan that outlines your entry, exit, and stop-loss points. You should also have a contingency plan in case of unforeseen events or market shocks. You should stick to your plan and follow it consistently. Do not let your emotions or impulses override your logic and discipline.
– Diversify your portfolio. Leverage can increase your concentration risk, which is the risk of losing a large portion of your portfolio due to a single or correlated asset. To reduce this risk, you should diversify your portfolio across different asset classes, sectors, regions, and strategies. This way, you can reduce your exposure to any specific risk factor and benefit from the power of compounding.
– Monitor your positions and performance. Leverage can change your positions and performance quickly and dramatically. You should monitor your positions and performance regularly and adjust them accordingly. You should also review your leverage ratio and margin level frequently and ensure that they are within your comfort zone and limits. You should also be aware of the market conditions and events that may affect your positions and performance.
Leverage can be a useful and profitable tool for investors and businesses, but it can also be a dangerous and costly one. By understanding the risks of over-leveraging and how to avoid them, you can use leverage more effectively and responsibly. Remember, leverage is not a substitute for skill, knowledge, or experience. It is a supplement that can enhance or diminish them. Use it with caution and care.
The Risks of Over Leveraging and How to Avoid Them – Financial Leverage Analysis: How to Use Debt Wisely and Avoid Over Leveraging
4. How to Measure and Monitor Your Financial Leverage Ratio?
One of the most important aspects of financial leverage analysis is how to measure and monitor your financial leverage ratio. This ratio indicates how much debt you are using to finance your assets and operations, and how well you can cover your interest payments and other obligations. A high financial leverage ratio can increase your returns on equity, but it also exposes you to more risks and volatility. Therefore, you need to find the optimal level of debt that suits your business goals and risk appetite, and keep track of any changes in your financial leverage ratio over time. In this section, we will discuss how to calculate your financial leverage ratio, what are the common benchmarks and industry standards, and how to use various tools and techniques to monitor your financial leverage ratio and adjust it as needed.
To calculate your financial leverage ratio, you need to know two key figures: your total debt and your total equity. Total debt is the sum of all your short-term and long-term liabilities, such as bank loans, bonds, leases, accounts payable, and accrued expenses. total equity is the difference between your total assets and your total liabilities, and it represents the amount of money that belongs to the owners or shareholders of the business. The formula for the financial leverage ratio is:
For example, if your business has $500,000 in total debt and $250,000 in total equity, your financial leverage ratio is:
This means that for every dollar of equity, you have two dollars of debt. Alternatively, you can express your financial leverage ratio as a percentage by multiplying it by 100. In this case, your financial leverage ratio is 200%.
The financial leverage ratio can vary widely depending on the industry, the size, and the stage of the business. Generally, a higher financial leverage ratio means a higher level of risk, as it implies that the business is more dependent on debt and has less financial flexibility. However, a higher financial leverage ratio can also mean a higher potential for growth and profitability, as it allows the business to take advantage of the leverage effect, which is the phenomenon where the returns on equity increase as the proportion of debt increases, as long as the return on assets is higher than the cost of debt. Therefore, there is no definitive answer to what is a good or bad financial leverage ratio, and it depends on the context and the objectives of the business.
However, there are some common ways to benchmark and compare your financial leverage ratio with other businesses in your industry or sector. One way is to use the average or median financial leverage ratio of your industry or sector as a reference point. You can find this information from various sources, such as financial databases, industry reports, or trade associations. For example, according to the U.S. Census Bureau, the average financial leverage ratio for the manufacturing sector in 2019 was 1.77, while the average financial leverage ratio for the retail trade sector was 2.35. This means that, on average, the retail trade sector was more leveraged than the manufacturing sector. Another way is to use the financial leverage ratio of your competitors or peers as a benchmark. You can obtain this information from their financial statements, annual reports, or websites. For example, if you are a software company, you might want to compare your financial leverage ratio with other software companies that have similar products, markets, or customers.
Once you have calculated and benchmarked your financial leverage ratio, you need to monitor it regularly and adjust it as needed. There are various tools and techniques that can help you with this task, such as:
– budgeting and forecasting: You can use budgeting and forecasting to plan and project your future income, expenses, assets, liabilities, and equity, and estimate how they will affect your financial leverage ratio. You can also use scenario analysis to test how your financial leverage ratio will change under different assumptions or conditions, such as changes in sales, costs, interest rates, or exchange rates. This can help you identify potential opportunities or risks, and prepare contingency plans accordingly.
– financial ratios and indicators: You can use other financial ratios and indicators to complement and supplement your financial leverage ratio analysis. For example, you can use the debt-to-asset ratio to measure how much of your assets are financed by debt, the debt-to-income ratio to measure how much of your income is used to pay your debt, the interest coverage ratio to measure how well you can cover your interest payments, and the debt service coverage ratio to measure how well you can cover your principal and interest payments. These ratios and indicators can help you assess your financial leverage ratio from different perspectives and dimensions, and provide more insights into your financial health and performance.
– Financial covenants and agreements: You can use financial covenants and agreements to set and enforce limits or targets for your financial leverage ratio. Financial covenants are clauses or conditions that are included in your debt contracts or agreements, and they specify the minimum or maximum levels of financial ratios or indicators that you must maintain or comply with. For example, your lender might require you to keep your financial leverage ratio below a certain threshold, or to reduce it gradually over time. If you fail to meet these covenants, your lender might impose penalties, increase your interest rate, or demand immediate repayment of your debt. Therefore, you need to monitor your financial covenants and agreements closely, and make sure that you do not breach or violate them.
– capital structure and financing decisions: You can use capital structure and financing decisions to change or optimize your financial leverage ratio. capital structure is the mix of debt and equity that you use to finance your business, and financing decisions are the choices that you make regarding how to raise or repay debt or equity. For example, you can increase your financial leverage ratio by issuing more debt, such as bonds or loans, or by repurchasing or retiring your equity, such as shares or dividends. Conversely, you can decrease your financial leverage ratio by issuing more equity, such as shares or retained earnings, or by repaying or refinancing your debt, such as bonds or loans. However, you need to consider the costs and benefits of each option, and weigh them against your financial goals and risk tolerance.
Measuring and monitoring your financial leverage ratio is a vital part of financial leverage analysis, as it helps you understand how much debt you are using to finance your business, and how well you can manage your debt obligations and risks. You can calculate your financial leverage ratio by dividing your total debt by your total equity, and compare it with the industry or sector averages, or with your competitors or peers. You can also use various tools and techniques, such as budgeting and forecasting, financial ratios and indicators, financial covenants and agreements, and capital structure and financing decisions, to monitor and adjust your financial leverage ratio as needed. By doing so, you can use debt wisely and avoid over-leveraging, and achieve your desired level of growth and profitability.
5. How to Optimize Your Capital Structure and Debt-Equity Mix?
One of the most important decisions that a firm has to make is how to finance its assets and operations. The choice of capital structure, or the mix of debt and equity, affects the firm’s profitability, risk, and value. There is no one optimal capital structure that suits all firms, as different firms have different characteristics, objectives, and constraints. However, there are some general principles and guidelines that can help firms optimize their capital structure and debt-equity mix. In this section, we will discuss some of these principles and guidelines, and provide some examples of how firms can apply them in practice.
Some of the factors that influence the optimal capital structure are:
– The cost of capital: The cost of capital is the minimum return that a firm has to earn on its investments to satisfy its investors and creditors. The cost of capital depends on the riskiness of the firm’s cash flows, the market conditions, and the tax system. Generally, debt is cheaper than equity, as debt holders have a prior claim on the firm’s assets and income, and interest payments are tax-deductible. However, as the firm increases its debt ratio, the cost of debt also increases, as the risk of default rises. The cost of equity also increases, as the equity holders demand a higher return for bearing more risk. Therefore, the firm has to balance the benefits and costs of debt and equity, and find the optimal debt ratio that minimizes the overall cost of capital.
– The financial flexibility: Financial flexibility is the ability of the firm to raise funds quickly and easily when needed, without compromising its long-term goals and strategies. Financial flexibility depends on the availability and accessibility of financing sources, the liquidity and solvency of the firm, and the degree of financial distress. Generally, equity provides more financial flexibility than debt, as equity does not have fixed obligations, maturity dates, or covenants. However, equity also has some drawbacks, such as dilution of ownership, loss of control, and higher issuance costs. Therefore, the firm has to balance the advantages and disadvantages of equity and debt, and find the optimal equity ratio that maximizes the financial flexibility.
– The signaling effect: The signaling effect is the impact of the firm’s financing decisions on the market perception of the firm’s quality and prospects. The signaling effect depends on the information asymmetry between the firm and the market, the reputation and credibility of the firm, and the market expectations and reactions. Generally, debt has a positive signaling effect, as it implies that the firm is confident about its future cash flows and profitability, and is willing to commit to fixed payments. Equity has a negative signaling effect, as it implies that the firm is uncertain about its future performance and growth, and is trying to take advantage of the overvaluation of its shares. Therefore, the firm has to consider the implications and consequences of its financing choices, and find the optimal signaling strategy that enhances the market value.
Based on these factors, some of the steps that a firm can take to optimize its capital structure and debt-equity mix are:
1. Estimate the current and target capital structure: The first step is to calculate the current debt ratio and equity ratio of the firm, and compare them with the industry averages and benchmarks. The firm can also use some financial models, such as the weighted average cost of capital (WACC) model, the capital asset pricing model (CAPM), or the modigliani-miller (MM) theorem, to estimate the optimal debt ratio and equity ratio that maximize the firm value. The firm can then set a target capital structure that reflects its desired level of leverage and risk.
2. Identify the financing needs and sources: The second step is to identify the amount and timing of the funds that the firm needs to finance its investments, operations, and obligations. The firm can use some financial tools, such as the cash flow statement, the budget, or the financial plan, to forecast the cash inflows and outflows, and determine the financing gap or surplus. The firm can then identify the potential financing sources, such as internal funds (retained earnings, depreciation, etc.), external funds (debt, equity, hybrid securities, etc.), or alternative funds (leasing, factoring, etc.), and evaluate their availability, suitability, and cost.
3. Select the optimal financing mix: The third step is to select the best combination of financing sources that meets the firm’s financing needs, while achieving the target capital structure and maximizing the firm value. The firm can use some financial criteria, such as the net present value (NPV), the internal rate of return (IRR), or the economic value added (EVA), to compare the benefits and costs of different financing alternatives, and choose the one that has the highest positive value. The firm can also use some financial ratios, such as the debt-to-equity ratio, the interest coverage ratio, or the return on equity (ROE), to monitor and adjust the financing mix, and ensure that it maintains an optimal level of leverage and performance.
For example, suppose a firm has a current debt ratio of 40%, and a target debt ratio of 50%. The firm needs $100 million to finance a new project that has an expected return of 15%. The firm’s current cost of debt is 8%, and its current cost of equity is 12%. The firm’s tax rate is 30%. The firm can use the WACC model to calculate the optimal financing mix as follows:
– The current WACC of the firm is: WACC = (0.4 x 0.08 x (1 – 0.3)) + (0.6 x 0.12) = 0.0928 or 9.28%
– The target WACC of the firm is: WACC = (0.5 x 0.08 x (1 – 0.3)) + (0.5 x 0.12) = 0.088 or 8.8%
– The NPV of the project using the current WACC is: NPV = ($100 million x 0.15) – ($100 million x 0.0928) = $5.72 million
– The NPV of the project using the target WACC is: NPV = ($100 million x 0.15) – ($100 million x 0.088) = $6.2 million
The firm can see that by increasing its debt ratio to 50%, it can lower its WACC and increase the NPV of the project. Therefore, the optimal financing mix for the project is to use 50% debt and 50% equity, or $50 million of each. The firm can then issue new debt and equity in the market, or use its existing debt and equity sources, to raise the required funds. The firm can also expect that by using the optimal financing mix, it can signal its confidence and quality to the market, and enhance its value.
How to Optimize Your Capital Structure and Debt Equity Mix – Financial Leverage Analysis: How to Use Debt Wisely and Avoid Over Leveraging
https://blogs.worldbank.org/en/allaboutfinance/firms-use-long-term-finance-why-how-and-what-do-about-ithttps://fastercapital.com/content/Financial-Leverage-Analysis–How-to-Use-Debt-Wisely-and-Avoid-Over-Leveraging.html
