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.
