Leverage is a term used in finance that can be simply understood as the use of borrowed money to conduct business. It can be dangerous and that is a piece of advice that has been heard from many great investors including the likes of Warren Buffett and Walter Schloss. In addition, we might also have heard about stories of companies that went bankrupt due to excessive debt. So is debt really that bad? Saying that leverage – or more simply, debt – is bad, in my opinion, is similar to saying that driving at a high speed is bad. Driving…
Leverage is a term used in finance that can be simply understood as the use of borrowed money to conduct business. It can be dangerous and that is a piece of advice that has been heard from many great investors including the likes of Warren Buffett and Walter Schloss.
In addition, we might also have heard about stories of companies that went bankrupt due to excessive debt. So is debt really that bad?
Saying that leverage – or more simply, debt – is bad, in my opinion, is similar to saying that driving at a high speed is bad. Driving at high speeds on the expressway makes a lot of sense, as long as you have the necessary driving skills and drive within safe speed limits.
Therefore, on its own, leverage is neither good nor bad. Instead, the question that investors might want to ask is how well we understand the risks and rewards of leverage to a company. In this article, I will focus on one positive aspect of leverage.
The return on equity, or ROE, measures the profit that a business can generate with the capital from shareholders that it has. Mathematically, it is given simply as:
ROE = Net profit / Equity
What the use of leverage in a business does is it can increase the ROE, thus increasing the long-term returns that shareholders of the business can enjoy.
To illustrate how leverage can improve ROE, let’s consider Singapore’s largest telecommunications outfit, Singapore Telecommunications Limited (SGX: Z74), as an example.
Source: Singapore Telecommunications
The above is a screenshot from SingTel’s website, showing a few metrics from the company’s past few financial years. The 2 figures that we will focus on are given in the red bubbles and they are the return on invested capital (ROIC) of 12.1% and return on equity (ROE) of 15.6%.
Using the numbers above, if we assume that all the capital in SingTel is equity-funded, our ROE will be the same as the ROIC, which is 12.1%. However, by including debt into its capital structure – roughly 25% of its capital is supplied by debt – SingTel has increased its ROE to 15.6%.
The above is a simple example of a form of activity known as financial engineering, whereby a company uses debt in its capital structure to increase shareholders’ return.
Key Foolish takeaway
Leverage is essentially a double-edged sword which can magnify both the returns and losses of its users.
Excessive leverage might be detrimental for companies going through difficult situations, such as companies from the oil and gas industry at the moment. Many of them have lots of debt on their balance sheets, which adds to their financial worries that stem from the sharp collapse in the price of oil.
Yet, wisely used, leverage can generate enormous returns for shareholders. In the U.S., there are real examples of executives like John Malone and Henry Singleton who have created legendary returns for their shareholders through the smart use of debt. For those of you who are interested, their stories are captured in the book The Outsiders.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn't own shares in any companies mentioned.