Course 207: Leverage
How Much Leverage Is Too Much?
In this course
1 Introduction
2 Leverage in Stock Investing
3 What Financial Leverage Is
4 How Much Leverage Is Too Much?

That said, just because a company's financial leverage is greater than that of the S&P 500 index doesn't mean it's reckless with its balance sheet. Take financials, such as bank holding company MBNA MBNA (best known for its credit cards) or financial conglomerate Citigroup C, which use far more leverage than most companies outside the financials industry. The average company in the financials sector has a financial-leverage ratio of more than 12, compared with about 2.5 for the S&P 500 as a whole. Banks and other lenders make much of their money off the difference between the rates at which they borrow and the rates at which they lend. Given these often-narrow spreads, their profits would be negligible if they didn't borrow a lot. Companies that would seem to have the least need for debt financing, such as those that are profitable and growing steadily, sometimes use financial leverage as a way to boost profitability. By taking on debt, a company can keep its equity small, thereby increasing the profit it can make as a percentage of that equity. In an attempt to pump up returns on equity, or ROE, for example, a steady grower such as food producer ConAgra CAG can take on extra debt. Utility companies, which have extremely stable cash flows, will often take advantage of their ample borrowing capacity for the same reason. Investors will want to make sure that a company with a high financial-leverage ratio relative to its industry can meet interest payments year in and year out. This means finding companies with consistent and reliable cash-flow streams that are sufficient to cover those interest payments. If something goes wrong, either with the company itself or with the general economy, a highly leveraged company can find itself in trouble, just as Long-Term Capital Management did. Leverage can be a good thing for both investors and businesses, but it is important to be aware of the very real dangers involved.

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