Understanding Leverage in Companies
Understanding Leverage in Companies
When analyzing a company for investment, one of the most critical—yet often overlooked—areas is leverage. Leverage simply refers to how much a company relies on borrowed money (debt) to run or grow its business. While leverage can accelerate growth and profits, it can also magnify risks if not managed well.
Thank you for reading this post, don't forget to subscribe!For retail and emerging investors, understanding leverage is essential to gauge a company’s financial health, risk profile, and long-term sustainability.
In this guide, you’ll learn:
-
What leverage means
-
Why companies use it
-
How to measure leverage
-
When leverage becomes risky
-
How you can evaluate it before investing
What Is Leverage?
Leverage refers to the use of debt (borrowings) to finance assets, operations, or expansion.
In simple terms:
Leverage = Using borrowed money to do more business than cash alone would allow.
Companies borrow for many reasons:
-
To build factories or infrastructure
-
To increase production
-
To expand into new geographies
-
To acquire businesses
-
To manage working capital
Leverage is not inherently good or bad—it depends on how effectively the company uses it.
Why Companies Use Leverage
1. To Accelerate Growth
Debt helps companies scale faster than relying solely on internal cash flows.
Example: A manufacturing company taking a loan to add a new production line.
2. Lower Cost of Capital
Debt is usually cheaper than equity.
Interest paid on loans is tax-deductible, reducing the net financing cost.
3. To Avoid Diluting Ownership
Raising money through equity issues reduces promoter holding.
Debt allows growth without giving away ownership.
4. To Improve Return on Equity (ROE)
If borrowed funds generate higher returns than the interest cost, shareholder returns increase.
This is known as positive leverage.
Types of Leverage You Should Know
1. Operating Leverage
This comes from the mix of fixed vs variable operating costs.
Companies with high operating leverage (e.g., manufacturing, airlines) have:
-
High fixed costs
-
Low variable costs
When sales rise, profits grow disproportionately—but when sales fall, profits drop sharply.
2. Financial Leverage
This refers to debt in the capital structure.
Companies with high financial leverage have:
-
Large borrowings
-
High interest costs
-
Higher default risk
Banks, NBFCs, telecom, and infrastructure companies typically carry higher financial leverage.
3. Combined Leverage
The overall effect of operating + financial leverage on profits.
Key Leverage Metrics Every Investor Must Track
1. Debt-to-Equity Ratio (D/E)
Measures how much debt the company has for every rupee of shareholder equity.
Formula:
Debt-to-Equity = Total Debt / Shareholder’s Equity
Ideal Range:
-
< 1 for most companies
-
Higher ratios acceptable for capital-intensive sectors like BFSI, infrastructure, telecom
2. Interest Coverage Ratio (ICR)
Shows if the company earns enough profits to pay interest.
Formula:
ICR = EBIT / Interest Expense
Interpretation:
-
3 = Comfortable
-
1–2 = Risky
-
< 1 = Cannot cover interest from earnings (red flag)
3. Debt-to-EBITDA
Indicates how long it would take to repay debt through operating earnings.
Safe Zone:
-
< 3 for most sectors
4. Free Cash Flow (FCF)
High leverage is dangerous if the company does not produce sustainable free cash flows.
Positive FCF = Company can comfortably service debt
Negative FCF + High Debt = Red flag
When Leverage Helps (Good Leverage)
Leverage can be beneficial when:
-
Debt is used for productive expansion
-
Earnings grow faster than interest costs
-
Cash flows are stable and predictable
-
The sector supports higher leverage (e.g., utilities, infrastructure)
-
Interest rates in the economy are low
Example:
A renewable energy company borrows to build new solar capacity and secures long-term Power Purchase Agreements (PPAs).
Its cash flows are stable → leverage works well.
When Leverage Becomes Dangerous (Bad Leverage)
High leverage becomes a threat when:
-
Revenue slows but interest costs remain constant
-
Debt is used for non-productive purposes (like covering losses)
-
Interest rates rise sharply
-
Promoter pledging increases
-
Cash flows are irregular or seasonal
Examples of risk events:
-
IL&FS collapse (high debt → cash flow mismatch)
-
Telecom AGR crisis (sector-wide debt stress)
Red Flags of Excessive Leverage
Investors should watch out for:
1. Falling Interest Coverage Ratio
Shows rising risk of default.
2. Increasing Short-Term Borrowings
Short-term loans must be repaid quickly → liquidity pressure.
3. Promoter Pledge Rising
Promoters pledging shares often indicates funding stress.
4. Frequent Refinancing of Loans
Suggests the company cannot generate enough cash to repay debt.
5. Negative Operating Cash Flow for Years
Even profitable companies can be stressed if cash is not coming in.
6. Debt Spiking Without Revenue Growth
Debt should translate into growth—not cover inefficiencies.
How to Evaluate Leverage Before Investing
Here’s a simple step-by-step framework:
Step 1: Check D/E Ratio
Compare with sector peers.
A high D/E alone is not bad—if the industry is capital intensive.
Step 2: Check Interest Coverage
Should be rising, not falling.
Step 3: Examine Cash Flow Statement
Is the company consistently generating positive operating cash flow?
Step 4: Review Management Commentary
Annual reports, concalls, and presentations can reveal:
-
Debt reduction plans
-
Capex strategy
-
Financing structure
Step 5: Assess Debt Maturity Profile
Short-term debt = higher risk
Long-term structured debt = manageable
Step 6: Check Credit Ratings
Downgrades are a clear stress signal.
Examples of Good vs. Bad Leverage
✔ Good Leverage Example
A cement company borrows ₹2,000 crore to expand capacity.
Demand in the sector is rising, and the company has strong operating margins.
Result:
Revenue and profitability grow → leverage boosts shareholder returns.
✘ Bad Leverage Example
A small manufacturing company borrows heavily to fund unrelated diversification.
Demand weakens and margins fall.
Result:
Debt servicing becomes difficult → profitability declines → share price collapses.
Should Retail Investors Avoid Highly Leveraged Companies?
Not necessarily.
But caution is essential.
Suitable for some investors:
-
Long-term investors who understand the sector
-
Investors seeking stable cash-flow businesses like utilities
Avoid if:
-
You are risk-averse
-
You are investing with a short-term horizon
-
Debt levels are rising without growth
A balanced approach is ideal:
Prefer companies with steady cash flows, declining debt, and high interest coverage.
Final Thoughts
Leverage is a powerful tool—one that can drive exponential growth or cause catastrophic collapse. For investors, the goal is not to avoid leverage entirely but to evaluate it intelligently.
A company with:
-
manageable debt
-
strong cash flows
-
clear growth strategy
-
stable management
…can use leverage to generate outstanding long-term wealth.
On the other hand, companies with:
-
rising debt
-
weak earnings
-
poor cash flows
-
excessive promoter pledging
…are best avoided before they become ticking time bombs.
Smart investing begins with understanding risk—and leverage is one of the biggest risks of all.
Related Blogs:
How to Use Fundamental Analysis for Indian Stocks
How to Read a Company’s Balance Sheet Before Investing
Understanding the Income Statement: A Beginner’s Guide
Understanding Cash Flow Statements for Investors
What Makes a Business Moat? Understanding Competitive Advantage
Disclaimer: This blog post is intended for informational purposes only and should not be considered financial advice. The financial data presented is subject to change over time, and the securities mentioned are examples only and do not constitute investment recommendations. Always conduct thorough research and consult with a qualified financial advisor before making any investment decisions.