What Is Overleveraged?
A business is said to be overleveraged when it is carrying too much debt when compared to its operating cash flows and equity. An overleveraged company has difficulty in paying its interest and principal payments and is often unable to pay its operating expenses because of excessive costs due to its debt burden, which often leads to a downward financial spiral. This results in the company having to borrow more to stay in operation, and the problem gets worse. This spiral usually ends when a company restructures its debt or files for bankruptcy protection.
Key Takeaways
- A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses.
- Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more.
- Companies typically restructure their debt or file for bankruptcy to resolve their overleveraged situation.
- Leverage can be measured using the debt-to-equity ratio or the debt-to-total assets ratio.
- Disadvantages of being overleveraged include constrained growth, loss of assets, limitations on further borrowing, and the inability to attract new investors.
Understanding Overleveraged
Debt is helpful when managed correctly, and many companies take on debt to grow their business, purchase necessary items, upgrade their facilities, or for many other reasons. In fact, taking on debt is sometimes preferable to other means of raising capital, for example, issuing stock. Taking on debt doesn't give up pieces of ownership of the company and outside participants aren't able to direct how the debt is used. As long as a company can manage its debt burden appropriately, debt can often help a business become successful. It is only when a company stops being able to manage its debt that it causes severe problems.
Overleveraging occurs when a business has borrowed too much money and is unable to pay interest payments, principal repayments, or maintain payments for its operating expenses due to the debt burden. Companies that borrow too much and are overleveraged are at the risk of becoming bankrupt if their business does poorly or if the market enters a downturn.
Taking on too much debt places a lot of strain on a company's finances because the cash outflows dedicated to handling the debt burden eat up a significant portion of the company's revenue. A less leveraged company can be better positioned to sustain drops in revenue because they do not have the same expensive debt-related burden on their cash flow.
Financial leverage can be measured in terms of either the debt-to-equity ratio or the debt-to-total assets ratio
Disadvantages of Being Overleveraged
There are many negative impacts on a company when it reaches a state of being overleveraged. The following are some of the adverse outcomes.
Constrained Growth
Companies borrow money for specific reasons, whether that be to expand product lines or to purchase equipment to increase sales. Loans always come with a specific time on when interest and principal payments need to be made. If a company that borrows with the expectation of increased revenues but hasn't been able to grow before the debt becomes due can find themselves in a difficult position. Having to pay back the loan without increased cash flows can be devastating and limit the ability to fund operations and invest in growth.
Loss of Assets
If a company is so overleveraged that it ends up in bankruptcy, its contractual obligations to banks that it borrowed from, come into play. This usually entails banks having seniority on a company's assets. Meaning that if a company cannot pay back its debt, banks are able to take ownership of a company's assets to eventually liquidate them for cash and settle the outstanding debt. In this manner, a company can lose many if not all of its assets.
Limitations on Further Borrowing
Before lending money, banks conduct thorough credit checks and evaluate the capacity of a company to be able to pay back its debt in a timely fashion. If a company is already overleveraged, the likelihood of a bank lending out money is very small. Banks do not want to take on the risk of possibly losing money. And if they do take on that risk, most likely the interest rate charged will be extremely high, making borrowing less than an ideal scenario for a company already struggling with its finances.
Inability to Gain New Investors
A company that's overleveraged will find it nearly impossible to attract new investors. Investors that provide liquidity in exchange for an equity stake will find a company that is overleveraged to be a poor investment unless they receive a large equity stake with a framework in place for recovery. Giving up large equity stakes is not ideal for a company as it loses control over the decision-making process.
FAQs
A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses. Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more.
What is an example of over leveraging? ›
Examples of over-leveraged
They're so over-leveraged they might not meet payroll, and even attendance is plummeting. It was the big over-leveraged papers that could no longer be supported by the advertisers, who'd been bought and sold so many times already.
Does higher leverage mean higher risk? ›
Higher leverage ratios mean greater potential returns, but also greater risk. The Equity Multiplier, also known as the Debt-to-Equity Ratio, is one way to measure financial leverage. It compares the total amount of debt in a company to its shareholders' equity and is a key indicator of financial risk.
What are the two outcomes of leverage? ›
The point and result of financial leverage is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out.
How much leverage is too much in real estate? ›
Between 70% and 80% of your equity is considered safe leverage. For example, between $70,000 and $80,000 of $100,000 in equity is considered safe to leverage. This is because your property could potentially depreciate and harm your equity.
What are the dangers of over leveraging? ›
Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more. Companies typically restructure their debt or file for bankruptcy to resolve their overleveraged situation. Leverage can be measured using the debt-to-equity ratio or the debt-to-total assets ratio.
What are the three 3 types of leverage? ›
There are three proportions of leverage that are financial leverage, operating leverage, and combined leverage. The financial leverage assesses the impact of interest costs, while the operating leverage estimates the impact of fixed cost.
What is leverage in simple words? ›
to use something that you already have in order to achieve something new or better: We can gain a market advantage by leveraging our network of partners. SMART Vocabulary: related words and phrases.
What are the consequences of leverage? ›
Accordingly, self-interested customers could decide to buy from other firms and thereby hampers sales growth. Moreover, higher leverage also affects employees who face higher unemployment risk, earnings losses, and higher losses of firm-specific human capital.
What is the risk associated with leverage? ›
The biggest risk that arises from high financial leverage occurs when a company's return on ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.
However, leverage can also pose some risks and other financial disadvantages, including: Increased financial risk resulting from the cash flow that will be required to service the debt. This additional pressure on cash flow can lead to an increased risk of insolvency and bankruptcy during a downturn.
Is leveraging a good or bad thing? ›
Leverage can be both good and bad, depending on how it is used and the context in which it is applied. Leverage refers to the use of borrowed funds or financial instruments to increase the potential return on an investment or business venture.
What are the disadvantages of leverage? ›
One major disadvantage of leverage is the potential for significant losses. As leverage amplifies the size of a position, even a small decline in the value of an asset can result in substantial losses.
What happens when leverage is too high? ›
However, when the leverage you use is so high that the margin supporting your trade is less than 10x to 20x your costs, your probability of losing begins to increase very rapidly. This is because costs eat away at the supporting margin, leading to a high probability of being closed out.
How to not be overleveraged in real estate? ›
To avoid over-extending yourself financially, maintaining a debt-to-equity ratio of 70% or less is key. An investor's equity in the property needs to be such that they can deal with any fluctuations in the market, unexpected costs, and other unforeseen circ*mstances.
What is leverage in real estate for dummies? ›
What Is Leverage? Leverage is the use of various financial instruments or borrowed capital—in other words, debt—to increase the potential return of an investment. It commonly used on both Wall Street and Main Street when talking about the real estate market.
What does it mean to have leverage over something? ›
If you have leverage, you hold the advantage in a situation or the stronger position in a contest, physical or otherwise. The lever is a tool for getting more work done with less physical force. With the right leverage, you might be able to lift a heavy box.
What is leveraging with example? ›
leverage verb [T] (BUSINESS)
to use borrowed money to buy an investment or company: Home equity is invaluable if you leverage it to build wealth. to use money to get more money: One of the easiest ways to leverage a charitable gift is to get your employer to match it.
What is an example of a high operating leverage? ›
A high operating leverage means a company has a large proportion of fixed costs compared to its total costs. An example might be an airline company. They have large fixed expenses, including airplane maintenance and employee salaries, which stay relatively the same even as the number of sales varies.
What is an example of leverage in real life? ›
Someone who wants to buy a home or a business leverages the cash they have by adding others' (typically, the bank's in the form of a loan) cash to it, similar to a joint venture.
