Leverage
Companies make use of debt capital and share capital to fund their businesses. Based on available resources and business strategies, a company may decide to rely on debt to provide more money for its business. It should be noted that both debt capital and share capitals are debts to others, unless the business is run by investors themselves. Upon the decision to increase debts, a business increases its risks. A credible and reputable business is able to persuade banks or suppliers to offer debentures, loan facilities, or credit facilities.
Debt may be secured or offered based on goodwill. But there is a limit to how far a company can go and how long it should rely on debt to run its business. Loans also involve interests while makes it more costly in compare to share capital, but they become more interesting, especially when low interest loans are available. In certain cases a business does not have a choice but to resort to credit facilities. On the other hand, banks may ask for assets or bonds to be offered as collateral.
What does leverage mean for shareholders?
A company is first and foremost responsible for returning profits to shareholders. A company may decide to use leverage to acquire assets or fund operations to return more profit and a better return on equity. In this case, it is said that the share capital is leveraged. Based on the amount of debt in relation to the share capital, a company can be considered highly leveraged or heavily indebted. This can affect share price in the market. In addition, if assets are offered as collateral for a large amount of debt, it makes sure that creditors get their money back in case the company is unable to repay debts, but it also means that shareholder investments are at risk. Therefore, steps towards the use of leverage have to be carefully contemplated.
How are loans and debts secured?
In order to make sure that a business can repay its debt, banks and other creditors ask for securities. In the case of a debenture or a large amount of loan, bonds or assets may have to be offered as collateral. When it comes to assets, a valuation is made to determine whether they are able to cover the debt. It is possible to secure debt using a fixed or floating charge. Any changes or deals will not be possible without the creditor’s consent when a fixed charge is over an asset.
Fixed charges are usually placed on non-current assets while floating charges are placed over current or circulatory assets. The company is free to use these assets even though they are secured, but if it fails to repay its debts or goes into liquidation, the floating change crystallizes. Crystallization occurs when a floating charge turns into a fixed charge. Secured assets and other collateral belong to creditors and company or shareholders cannot have any claim on them. A charge holder can ask the court to appoint an administrator, who takes care of crystallization in case of liquidation.
Leverage is one of the methods of acquiring funds. This method may affect share values if the company becomes highly leveraged and unable to repay debts. Debts are usually offered against collateral to make sure the company is able to pay back the loan.
