Question

10. How do you balance over-leveraging a portfolio company while taking advantage of attractive financing markets? Should there be controls in place to avoid over-leveraging?

Answer 1

Overleveraged is a balance sheet condition where the entity is incapable of servicing its debt load (intrests payments) with available capital sources.

Overleveraging occurs when a business has borrowed too much money and is unable to pay intrest payments, principal repayments its maintain payments for the businesses 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.

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 company that is less leveraged can be better positioned to sustain drops in revenue because they donot have the same expensive debt related burden on their cash flow.

To balance overleveraging a potfolio company while taking advantage of attractive financing markets, there are some measures used:

1. Debt ratio- The ratio of debt to total capital.

2. Debt equity ratio: The ratio of debt to equity.

3. Intrest coverage: The ratio of net operating income or EBIT to intrest changes.

In the solvency, shareholders are the worst sufferers. Thus, we find that, financial leverage is a double edged sword. It increases return as well as risk.

A trade off of between return and risk will have to be struck to determine the appropriate amount of debt.

There are many industry sectors in which companies operate with a high degree of financial leverage. Retail stores, airlines, grocery stores, utility companies, and banking institutions are classic examples. Unfortunately the excessive use of financial leverage by many companies in these sectors has played a paramount role in forcing a lot of them to file for bankruptcy.

Examples include R . H Macy 1992, Trans world airlines, Great Atlantic and pacific tea co., and Midwest Generation.

Moreover excessive use of financial leverage was the primary culprit that led to the U.S financial crisis between 2007 and 2009. The demise of Lehman Brothers and a host of other highly leveraged financial institutions are prime examples of the negative ramifications that are associated with the use of highly levered capital structures.

With this in mind, the management of the company should take into account

1. the business risk of the company.

2. The company's tax position.

3. The financial flexibilty of the company capital structure.

4. The company degree of managerial aggressiveness when determining the optimal capital structure.