What Is Overleveraged?
A business is said to be overleveraged when it is carrying too much debt when compared to its operating cash flows and equity. An overleveraged company has difficulty in paying its interest and principal payments and is often unable to pay its operating expenses because of excessive costs due to its debt burden, which often leads to a downward financial spiral. This results in the company having to borrow more to stay in operation, and the problem gets worse. This spiral usually ends when a company restructures its debt or files for bankruptcy protection.
Key Takeaways
- A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses.
- Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more.
- Companies typically restructure their debt or file for bankruptcy to resolve their overleveraged situation.
- Leverage can be measured using the debt-to-equity ratio or the debt-to-total assets ratio.
- Disadvantages of being overleveraged include constrained growth, loss of assets, limitations on further borrowing, and the inability to attract new investors.
Understanding Overleveraged
Debt is helpful when managed correctly, and many companies take on debt to grow their business, purchase necessary items, upgrade their facilities, or for many other reasons. In fact, taking on debt is sometimes preferable to other means of raising capital, for example, issuing stock. Taking on debt doesn't give up pieces of ownership of the company and outside participants aren't able to direct how the debt is used. As long as a company can manage its debt burden appropriately, debt can often help a business become successful. It is only when a company stops being able to manage its debt that it causes severe problems.
Overleveraging occurs when a business has borrowed too much money and is unable to pay interest payments, principal repayments, or maintain payments for its operating expenses due to the debt burden. Companies that borrow too much and are overleveraged are at the risk of becoming bankrupt if their business does poorly or if the market enters a downturn.
Taking on too much debt places a lot of strain on a company's finances because the cash outflows dedicated to handling the debt burden eat up a significant portion of the company's revenue. A less leveraged company can be better positioned to sustain drops in revenue because they do not have the same expensive debt-related burden on their cash flow.
Financial leverage can be measured in terms of either the debt-to-equity ratio or the debt-to-total assets ratio
Disadvantages of Being Overleveraged
There are many negative impacts on a company when it reaches a state of being overleveraged. The following are some of the adverse outcomes.
Constrained Growth
Companies borrow money for specific reasons, whether that be to expand product lines or to purchase equipment to increase sales. Loans always come with a specific time on when interest and principal payments need to be made. If a company that borrows with the expectation of increased revenues but hasn't been able to grow before the debt becomes due can find themselves in a difficult position. Having to pay back the loan without increased cash flows can be devastating and limit the ability to fund operations and invest in growth.
Loss of Assets
If a company is so overleveraged that it ends up in bankruptcy, its contractual obligations to banks that it borrowed from, come into play. This usually entails banks having seniority on a company's assets. Meaning that if a company cannot pay back its debt, banks are able to take ownership of a company's assets to eventually liquidate them for cash and settle the outstanding debt. In this manner, a company can lose many if not all of its assets.
Limitations on Further Borrowing
Before lending money, banks conduct thorough credit checks and evaluate the capacity of a company to be able to pay back its debt in a timely fashion. If a company is already overleveraged, the likelihood of a bank lending out money is very small. Banks do not want to take on the risk of possibly losing money. And if they do take on that risk, most likely the interest rate charged will be extremely high, making borrowing less than an ideal scenario for a company already struggling with its finances.
Inability to Gain New Investors
A company that's overleveraged will find it nearly impossible to attract new investors. Investors that provide liquidity in exchange for an equity stake will find a company that is overleveraged to be a poor investment unless they receive a large equity stake with a framework in place for recovery. Giving up large equity stakes is not ideal for a company as it loses control over the decision-making process.
FAQs
Meaning of over-leveraged in English
an over-leveraged person or business has borrowed too much money in relation to their ability to pay it back: When prices collapsed, many over-leveraged developers went bankrupt.
What happens when you have too much leverage? ›
Key Takeaways. A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses. Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more.
What does it mean to be overleveraged in real estate? ›
Being over leveraged in real estate essentially means that an investor has borrowed more than they can pay back. This can lead to major financial issues and eventually foreclosure and bankruptcy, if investors cannot find a way to cover their monthly repayments, or if the value of the property declines too much.
What happens when a company is overleveraged? ›
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.
What is an example of over leveraged? ›
Examples of 'overleveraged' in a sentence
- When the banking system collapsed, consumers were exposed as overleveraged. ...
- Yet even at that level, this is not an overleveraged business. ...
- We borrowed too much, we were overleveraged.
Overleveraging can be extremely risky and is one of the most common mistakes novice traders make. The primary risk is that traders can quickly lose more money than they can afford to repay, leading to financial difficulties or even bankruptcy.
What is the simple meaning of leverage? ›
uncountable noun. Leverage is the ability to influence situations or people so that you can control what happens. His position as mayor gives him leverage to get things done. Synonyms: influence, authority, pull [informal], weight More Synonyms of leverage.
Is leverage a bad thing? ›
Financial leverage is important as it creates opportunities for investors and businesses. That opportunity comes with high risk for investors because leverage amplifies losses in downturns. For businesses, leverage creates more debt that can be hard to pay if the following years present slowdowns.
What is a synonym for leveraging? ›
exploiting. abusing. manipulating. milking. playing (on or upon)
How much is too much leverage in real estate? ›
How much leverage is safe in real estate? Between 70% and 80% of your equity is considered safe leverage. For example, between $70,000 and $80,000 of $100,000 in equity is considered safe to leverage. This is because your property could potentially depreciate and harm your equity.
Full investment loss: There is always a risk of losing your entire investment when taking on leverage, especially if the worst-case scenario occurs and the property fails to generate sufficient returns to cover the debt obligations.
What is an example of leverage in real estate? ›
Example of Leveraging
Consider the common real estate purchase requirement of a 20% down payment. That's $100,000 on a $500,000 property. By putting down only 20% of the money down and borrowing the rest, the buyer essentially uses a relatively small percentage of their own funds to make the purchase.
What does it mean to be over leveraged? ›
verb (used with or without object)
, o·ver·lev·er·aged, o·ver·lev·er·ag·ing. to get into too much debt: The hotel was overleveraged and had an insufficient cash flow.
How do I know if I'm over leveraged? ›
To determine if you are over-leveraged, check your debt-to-income ratio, monthly cash flow, and overall financial situation. Signs of over-leverage include using credit cards for everyday expenses, taking out new loans to pay off old loans, having trouble making debt payments, and constantly worrying about finances.
What happens when leverage is too high? ›
When used effectively, debt can generate a higher rate of return than it costs. However, too much is dangerous and can lead to default and financial loss. Leverage varies by industry, as certain types of companies rely on debt more than others, and banks are even told how much leverage they can hold.
What does too leverage mean? ›
Leverage is the ability to influence situations or people so that you can control what happens. His position as mayor gives him leverage to get things done. Synonyms: influence, authority, pull [informal], weight More Synonyms of leverage. 2. transitive verb.
What does it mean if something is leveraged? ›
Leverage refers to using debt (borrowed funds) to amplify returns from an investment or project. Companies can use leverage to invest in growth strategies. Some investors use leverage to multiply their buying power in the market.
What does it mean if someone is highly leveraged? ›
Leverage is the amount of debt a company has in its mix of debt and equity (its capital structure). A company with more debt than average for its industry is said to be highly leveraged.
What does leverage over you mean? ›
Having “leverage” over someone usually means that you know something about them that no one else does. They are therefore willing to do just about anything for you in return for you keeping their secret.
