The financial term for using others’ money is known as “leverage”. Leverage is the use of borrowed funds to increase one’s trading position beyond what would be available from the equity or personal funds alone. Leveraging is when you borrow a certain amount of money in order to expand the potential return of an investment you are intending to make. In a rising market, leverage can amplify your returns, leading to enormous gains and can make you very wealthy. However, it comes with a catch. In a flat or falling market leverage can do the opposite, by magnifying your losses. That’s the tricky bet when it comes to borrowing to invest. However, the concept will work only when the markets are bombing, businesses are producing and selling enough and are rising. Thus, leveraging involves a high level of risk. The greater the amount of leverage on the capital you apply, the higher the risk that you will assume. You got it right! That is why we call it as a double-edged sword because it increases winning and losing positions equally. If an investor decides to rely on leverage in order to invest and the investment moves against the investor, his/her losses may appear to be far larger than they would have been, if the investment had not been leveraged. Therefore, it is convenient to say that leverage amplifies both profits and losses.
Let us go into little more details. On one hand, when financial cost of ‘fixed bearing securities’ is less than the return on investment, the financial leverage will help to increase return on equity and earning per share for investors. That is where the condition of ‘Trading on Equity’ will emerge. The firm will also benefit from the saving of tax on interest on debts etc. We’ve all heard the rags to riches property investment stories that make it all sound so easy. These tales usually have two vital ingredients, lots of leverage and a strongly rising market. Toyota, General Electronics, Walmart, CNN, British Airways, Sony, and others all displaced competitors with stronger reputations and deeper pockets. Their secret? Of course, in each case, the winner had greater ambition than its well-endowed rivals. Winners also find less resource-intensive ways of achieving their ambitious goals. This is where leverage complements the strategic allocation of resources. However, when the cost of debt will be more than the average returns for even a very successful company, it will affect the return of equity and earnings per shares unfavorably and as a result, a firm can be under financial distress. This is why this “double-edged sword” can be very difficult to handle during times of crisis as the whole world is facing today.
Can you imagine the impact of this so-called sharp weapon “leverage” would have on businesses amid the Covid-19 outbreak? Be it a small business or a large one, if they are using some borrowed funds; they are actually relying on leverage. They all need to service these debts by paying interest and principal installment. Imagine, what will happen if they do not have enough revenue to serve these debts? They will try to refinance debt, if they are unable to get refinance then they would fail in meeting up the fixed financial costs of these debt funds and then they face legal actions against them and which might lead to bankruptcy even. Yesterday, RBI Governor Shaktikanta Das said all commercial banks, regional rural banks, small finance banks, cooperative banks, and non-banking financial companies are permitted to allow a three-month on EMI payments for term loans outstanding on March 1, 2020. This elucidates the understanding of the central banks against the expected adverse effect of leverage on companies using debt funds. It goes without saying that many factors including the nature of the product or service the business deals in, the Firm’s age and ownership structure also decide the survival or fall of a firm during the time of crisis.
Well, the Central Bank of India understands the functioning, power and possible threats of this so-called sword very well. That is why, The Governor of Reserve of Bank (RBI) of India, Shaktikanta Das on March 27’ 2020 cut repo rates by 75 basis points and allowed lending institutions to provide a three-month moratorium on EMI repayment on all term loans. This is expected to ease the pressure of EMIs on retail loan borrowers as the country fights the deadly COVID-19. This means that no penal action will be taken against borrowers of home loans, personal loans, car loans, credit card EMIs, among others for not repaying EMIs for three months for the period March to May and thus, borrowers could get three months times to service the debt without any penalty. Though the macroeconomic fundamentals of the Indian economy are sound, and in fact stronger than what they were in the aftermath of the global financial crisis of 2008-09. Even then Leverage, the double-sided sword remains a significant determinant of a firm’s performance amid Covid-19.
Leveraging is like dynamite- a powerful weapon in good time but deadly during a crisis like Covid-19.