Definition
Leverage involves using various financial tools and capital to boost a company's potential returns. Companies make use of leverage for financing their operations and boosting net profits. Companies often rely on debt financing to expand their business operations, which would not be possible by only using equity.When a company's debts are more than its equity, it is said to be overleveraged. An overleveraged condition may result in a company's inability to repay principal borrowings and interest and, in some cases, to pay for its operating expenses.
Example
A company's leverage can be estimated by using financial ratios like debt-to-equity ratio ordebt-to-total assets ratio.
Why it matters
It is important for companies to keep a close watch on their leverage and ensure that it is not overleveraged for a prolonged period. This is because being overleveraged can lead to a fall in financial performance and this may force the company to borrow more.Companies that are overleveraged for longer periods may end up restructuring their debt or eventually filing for bankruptcy. Being overleveraged means constrained growth, restrictions on additional borrowing, loss of assets, and inability to attract new investors.