The Impact of Financial Leverage in Stock Investment
Financial leverage is one of the main ways to determine how risky a company can be and what kind of returns it could benefit from investing in its stock. For companies with a leverage ratio higher than 1.5, the stock price tends to fall around 15%–20% on average during market downturns because high leverages increase their exposure to market risks as well. During the stock market drawdown of 2018 energy companies that had financed themselves with lots and lots of debt saw their shares drop by over a third on account of market volatility.
Companies with a leverage ratio of less than 1 (Apple having a Leverage Ratio in 2023 at the level of 0.72) were more priced-stable during market downturns, had low stock price volatility and had Return on Equity always above +20%. This means firms with low leverage enjoy a greater degree of financial stability, which is beneficial for investors when the capital markets turn sour.
Financial Leverage Risks in the Bond Market
Financial leverage is also an issue in the bond market since it directly affects one of the rating agencies’ credit ratings, which will determine how much more a $1000 par value issuer needs to pay for its issued debt. Data from Standard & Poor’s show that companies with leverage of over 2 are, on average, rated BBB or lower, which implies a much greater risk of default when it comes to debt repayments. Take WeWork with a leverage ratio of over 3 back in 2020; its bond credit rating was slashed to junk, and the interest rate soared above 10%, which raised financing costs significantly.
Coca-Cola is one of the bond-related plays listed here, and it can borrow at 2% with an AA rating because its leverage ratio (debt/EBIT) is under 1. Moreover, lower-leverage companies offered better bond yields than highly leveraged corporations in the 2022 global bond market turmoil. Low-leverage company bonds yielded an average of 3.5%, while high-leverage companies’ bond yields clocked in at more than 6%.
Analyzing changes in risks associated with different interest rates, the Maturity demographic indicates that an average company raises its financing costs by 1.5% when it increases its leverage ratio one step (i.e., to +0. That means high-leverage operators will be squeezed even harder by rising interest rates, leaving them more exposed to potential credit rating downgrades and adverse market perceptions.
Financial Leverage Assessment in Fundamental Analysis
Financial leverage is also among the critical indicators in fundamental analysis especially towards assessing a company’s long-term health. A bankruptcy probability of 15% is for companies with a leverage ratio above 2 and just about the opposite, namely only around two percent, which already sounds much better even if almost all bankruptcies are below this coveted level. When the market shock came in 2008 due to a financial crisis, Lehman Brothers’ leverage ratio of more than two had grown excessive; ultimately, it ceased operating, whereas Walmart, with less leverage, was able to ignore and (mostly) turned profit as usual.
In terms of expansion potential, a company having a leverage ratio above 1 would most likely employ borrowing for a much faster increase in size during times such as Tesla, which had its Leverage Ratio touching 2 well through the period between the start and end of year-2021 yielding Revenue to Grow by >50%. But as this group grows, there is a significant downside: these companies will be highly geared (due to the huge debts taken on) and consequently vulnerable; simmering economic conditions threatening to increase that vulnerability further, thereby constraining debt serviceability, in turn, damaging cash flows and profit margins.
A lower-leverage company has more leeway in its financial position. Microsoft maintained a leverage ratio below 0.7; the company has focused on self-sustained business operations since then, even during slow revenue movement that minimizes the need for external financing and operational risks are also reduced to a great extent as well.
Financial Leverage Standards Across Different Industries
Various industries have vastly different levels of financial leverage that can be objectively considered. Average leverage ratios for utilities at 2.5 are the highest out of any sector, as they have stable cash flow and can handle more debt. According to Morgan Stanley research, the Duke Energy leverage ratio is 2.3 and defaults easily with stable cash flow to still be a low-risk default at A-level credit ratings.
Tech companies, on the other hand, have generally had lower leverage ratios, ranging from 0.5 to as much as 1 times over time. In 2022, Meta had a leverage ratio of.060, but this lower level of relative debt gives the company financial flexibility to sustain large swings in revenues. In the tech world, where these companies have super-scalable but lumpy revenues AND, in many cases, extremely sensitive borrowings, they used to come upside down when times got tough.
The average leverage ratio in retail reaches around 1.5. Walmart has maintained it within the range of 1.4-1.6 (%). Retail is a capital-intensive industry with a reasonably steady cash flow, so it should have moderate financial leverage to balance growth and financial risk.
The Balance Between Financial Leverage and Shareholder Returns
This can allow for higher returns to shareholders through reasonable use of financial leverage. Firms with leverage of between 1.5 and two can expect to see shareholder returns rise by 10-15 percent. One example is the case of American Airlines, looking to increase its fleet and market share quickly by going into higher leverage, resulting in more than 20% return on shareholders at one point. But too much leverage can also cause bad returns to fall off a cliff fast. As an example, during the last global drop in oil price from 2018 onward already those airline companies with a leverage ratio over 2 saw shareholder returns getting close to -10%.
Companies with a leverage ratio of 1 or below have lower returns, but the risks are also significantly less. Consider McDonald’s, for example, which is at 8%-10% shareholder returns with nice long-term stability and growth, all while having a leverage ratio of less than.
