How Is Financial Leverage Related to Bankruptcy?

Financial leverage uses borrowed funds to expand a business's operations in such a way that both gains and losses are magnified. Financial leverage may be measured by debt-to-equity or debt-to-total-capital ratios. Bankruptcy happens when a business has lost more than what it originally put in as equity capital and, as a result, the remaining assets as valued cannot cover the total outstanding debt. Financial leverage presents potential negative effects on business profits and asset valuation, raising bankruptcy concerns.

While financial leverage raises the scale of business activities for potentially higher profits, it can also increase the magnitude of potential losses. When the business makes enough profits using borrowed funds, and the profits are added to the accumulation of equity capital over time, any outstanding debt is likely to be paid off when due. However, in business downturns, any losses likely have multiplied, depending on the amount of debt used. Increased losses can be an issue for ongoing debt management, contributing to potential bankruptcy worries.

The use of leverage is often perceived as increasing financial risk. Such negative perception may have unfavorable effects on a firm's ability to generate revenue and maintain certain levels of cash flow. Some customers may choose to deal with other, less risky companies, hurting sales. Suppliers concerned about potentially not getting paid may tighten trade credit standards by allowing smaller accounts payable, putting strains on existing cash reserves. Therefore, less cash coming in from customers and more cash going out to suppliers reduces the amount of funds available for making debt payments.

Aware of the magnifying effect of financial leverage on potential losses, a company's management may become overly cautious when choosing investment projects that are financed with debt. To reduce the possibility of incurring potential increased losses, management may try to avoid risky projects. However, riskier investments often generate higher returns if they turn out to be successful. By focusing on only safe projects, a company can earn only average returns, reducing its competitiveness over time and its ability to fend off any future bankruptcy threat.

Financial leverage has more impact on equity holders than on creditors. Debt uses increase the risk for equity holders, as creditors have a prior claim on cash flows. Such repayment standards shift business risk and concentrate it on equity holders. As risk for equity holders increases, the cost of their equity investments also increases. The higher the investment cost is, the lower the value of the investment. Thus, a lower appraisal of asset value suggests potentially lowered proceeds from asset sales, reducing a business's ability to cover debt payments.

Companies can go out of business with or without financial leverage because of the inherent business risk in operating any enterprise. However, the decision to use debt adds additional risk that can further compound the effect of business risk in times of operation losses. Still, companies will always be tempted to use debt to fund parts of their operations. Debt financing is normally cheaper than equity financing, as debt holders do not bear the ultimate business risk. An optimal capital structure in which the portion of debt relative to equity is not excessive may enable a business to take advantage of the low-cost debt financing while avoiding potential bankruptcy threats posed by financial leverage.