Leveraging: Trapped in top gear

Updated: Jan 21 2002, 05:30am hrs
Leverage: use borrowed capital for (an investment) expecting the profits made to be greater than the interest payable [as per the Concise Oxford Dictionary].

Obviously, expectations of profits in uncertain conditions would bring in the probability of losses as leverage makes things go faster - up or down. One view is that high leverage means high profitability for shareholders trading on thin equity. However, for a financially geared company, a small change in its earnings could have a very large proportionate impact on the profits for shareholders.

Crisil head-corporate ratings Mukesh Agarwal says, No industry or sector can justify a high gearing as it always increases the financial risk of the company. As companies increase their gearing, credit ratings could fall, resulting in a reduction in the investment quality of their bonds.

With maximisation of shareholder value as the objective for determining the capital structure, a company will seek the combination of debt and equity that provides the best risk-return trade off. Financial leverage causes increasing fluctuations in return on equity and increases the risk premium and the rate of debt.

The market operates to produce a balance of debt and equity finance by restraining debt creation beyond the level at which a borrowing company can be expected to sustain interest charges and repay principal without prejudicing the security and expectations of its equity shareholders. Identifying the quantum of debt necessary to maximise share price remains a daunting task for every financial officer.

As leverage increases, investors raise the required rate of return on equity. Till such time as the increase in the cost of equity to the company does not offset the benefit of using the cheaper debt funds, the company still has debt raising capacity. Theoretically, debt can be a fund raising option till such time that returns are greater than the total cost of capital. Therefore, debt could be used as growth capital.

As the risk profile of the company increases, the probability of bankruptcy could have a negative effect on the value of the company and on its cost of capital. The shareholders will be burdened with higher interest costs charged by creditors and a lower valuation of the company. Prabhudas Liladhar head of research Nirjhar Gupta says: Where a company has a high gearing, the market will usually give it a low valuation. As a result, investors are likely to penalise the stock price of the company as leverage increases.

A company that is highly geared (or has used its debt raising capacity) will find it increasingly difficult to raise funds through the debt or equity route. Potential investors will demand extremely high returns which will be at the cost of existing stakeholders. As bond holders take a priority over shareholders, there is an increase in volatility in equity as companies lose the ability to offer an increasing earnings stream. Globally, as the markets fell in the recent past, many of the leveraged companies saw their stocks turn volatile.

However, the disadvantages of leveraging should not dissuade companies from accessing the debt markets. A company carrying little or no debt and keeping a large cash surplus is often not making the best return on investment for company shareholders. The investors would rather take their money and invest it elsewhere for a better return.

The obvious advantage of debt for the borrower remains tax deductibilty of interest payments and greater efficiency in expenditure management compared to dividend payments. An ancillary benefit for companies with heavy leveraging is that it often brings in a greater amount of efficiency in operations. Businesses are required to cut waste to a minimum due to the discipline introduced by the debt.

The market practices and conventions also determine the acceptable debt-equity mix eg in Japan, where companies resort to loans regularly, will have a higher gearing than other markets. The acceptable gearing level would also differ between industries. For instance, seasonal and cyclical industries should have a conservative gearing level. The impact of gearing on the ratings criteria is determined by the environment peculiar to a sector or industry, says Mukesh Agarwal.

So when does it make sense to invest in leveraged companies given the potential for a huge swing in either direction Investors seeking exposure to bonds can either invest directly in bonds or buy stock in companies that are highly leveraged. Especially in cases where the markets are not adequately reflecting the value of the equity of the company and the company is making good use of its leveraged position.

Says Nirjhar Gupta: Investment in geared companies requires a call to be taken on the performance of the company or its turnaround potential.

It is important for investors to find out which companies are using leverage effectively and which are not. The companies should be growing earnings, book value and cash flows. Analysts point out that in addition to a conducive business environment, cash holdings of highly leveraged companies need to be sufficient or else fragility increases.

What do investors need to look out for while investing in highly geared companies A company with a high gearing is likely to be very sensitive to changes in interest rates. Also the vulnerability to bankruptcy will be higher during a liquidity crisis. The performance results of higly geared companies tend to exaggerate the underlying trend in the market. Although shareholders benefit immensely from gearing when the business is doing well, the reverse case results in tougher times.

Analysts point out that in India the chances of a negative capital market reaction to gearing are minimal as the shares of a large number of debt heavy companies are already quoting at low market prices.

In the current uncertain economic scenario, it is unlikely that a small-time investor will show interest in leveraged companies, in spite of the potential for massive upside. Specialists such as junk bond investors could make some moves as they have both the expertise and the appetite. As the economic growth and corporate margins reduce, investors are increasingly losing faith in leveraged transactions and confidence in such companies.

Globally, investors have become increasingly conservative, especially as the previously promised over-optimistic returns and market expectations have failed to materialise.