Published: 3 November 2025
How does financial leverage add corporate value?
It’s because of tax, and the way corporate borrowing costs are tax-relieved. This is known as the “tax shield”. The tax shield is the benefit to a taxpayer of the tax deductibility of certain business expenses - including borrowing costs - thus reducing their taxable income and their tax expenses.
Borrowing costs - including debt interest - are normally tax-deductible. This gives rise to tax saving benefits and reduces the after-tax cost of debt for corporate borrowers. The greater the financial leverage, the greater the amount of debt, and the greater the related tax saving for the corporate taxpayer.
Can financial leverage be too high?
All borrowing adds risk for the borrower. The more the borrowings, the greater the financial risk. This applies whether the borrower’s debt finance is in the form of bank borrowings, bonds, or indeed any other form.
What are the main risks of borrowing?
Firstly, any time our organisation borrows, the most fundamental risk is that we may be unable to make the required repayments. This is a breach of the contract documentation, known technically as an event of default. Following an event of default, lenders will enjoy additional rights under the documentation, to force the borrower to the negotiating table. For example, lenders may be given the right to accelerate the borrower’s obligations, making all amounts due and payable immediately, notwithstanding the original scheduling.
The second risk is financial covenants. Most borrowing documentation will contain financial covenants in favour of the lender. Under these financial covenants, the borrower promises to maintain key financial ratios at levels representing safety and reassurance for the lender. For example, to maintain minimum interest cover ratios and/or minimum debt to equity ratios. Breaching a financial covenant is generally also an event of default, with similar adverse consequences to those discussed above (in relation to non-payments). A related risk for borrowers is loss of operational flexibility when ensuring that covenants are complied with.
A third area of risk are potentially adverse changes in formal and informal perceptions of the organisation’s total credit and investment risk. Formal evaluations will include the organisation’s credit rating, if it has one. The credit rating agency performs an independent and ongoing evaluation of the borrower’s credit strength. The agency publishes its evaluation in the form of a credit rating. For example, BB+ is a key rating marking the boundary between lower risk investment grade, and higher risk speculative grade securities. The borrower’s levels of leverage are a key driver of its formal credit rating, with higher levels of leverage leading to worse ratings.
A worsening of the credit rating is known as a downgrade. Any downgrade in the rating will generally result in increases in the borrower’s cost of borrowing and a reduction in available sources of funding. It may also depress the borrower’s share price.
Additional borrowing costs and related expenses are sometimes known as financial distress costs. Excessive leverage and borrowings destroy corporate value through financial distress costs and increased risks of bankruptcy.
Notice that financial distress affects the market value of equity. This means market based measures of leverage can increase further, outside of the control of the company. Accordingly, prudent management will set a safety margin and correspondingly more conservative levels of leverage. Reducing leverage is known as “deleveraging”.
What are the main measures of leverage for non-financial corporates?
Leverage can be measured in a number of different ways. Balance sheet measures for non-financial corporates include Debt to Equity (D/E), and Debt to Capital Employed (D/D+E). For example, if our organisation has debt of 30 and equity of 30, its Debt to Equity ratio is 30/30 = 100%, while its Debt to Capital Employed ratio is 30/(30+30) = 50%. Knowledge, care, consistency and transparency are essential to producing fully comparable and understandable figures for our colleagues.
Other key measures include interest cover ratios, debt to income ratios and cash flow to debt ratios. Credit rating agencies use these widely in practice, as part of their overall rating evaluations.
How are target leverage levels set in practice?
Leverage levels will be a key part of an up to date treasury policy for the organisation. As a minimum, these will ensure compliance with current borrowings documentation. As part of targeting a minimum credit rating, they may also incorporate more conservative levels, mindful of the rating agencies’ processes.
“There is no rule that says a particular ratio level indicates above- or below-average risk. It will vary by industry. A very creditworthy property company will have low interest cover and high debt to capital employed. Similar levels in an industrial company may send lenders running for the hills. Ratios can be used most productively when making comparisons between companies in similar sectors and over time. For any one firm, more than one measure might be required to properly understand the financial risk.”
(Will Spinney FCT, former Associate Director of Education, ACT)
Overall the organisation can add the most value by borrowing the greatest amount that it can service safely, including during any future downturn. In turn, this depends on the stability of its operating and other cash flows during a recession. Some organisations will calculate a “recession cash flow” to evaluate the appropriate level.
Cash flow is fundamentally important
“… cash is the lifeblood of the business. It is imperative to be able to smell and follow the cash trail.”
(André Khor, Group Chief Financial Officer & Deputy Chief Executive Officer, PT Chandra Asri Pacific Tbk)
Do banks measure leverage differently?
Yes, there are two key differences. Firstly, compared with non-financial corporates, banks have much higher levels of financial leverage. Secondly, and partly for this reason, financial institutions’ leverage is closely regulated, under strictly defined measures.
The main regulator in the UK is the Prudential Regulation Authority. Prudential management, regulation and supervision relate both to the safety and stability of individual banks and financial institutions, and of the whole of the financial system.
Operational leverage and business risk
The property company mentioned above is in a sector that has stable operating cash flows, and relatively low business risk. We can also say it has low operational leverage, meaning that the operating cash flows have low variability.
Prudent financial management will generally avoid combining high operating leverage with high financial leverage. Acceptable combinations are more likely to be low operating leverage with higher financial leverage – as in the case of the property company – or high operating leverage with low financial leverage.
One exception to this is private equity, which may introduce high financial leverage and risk with the goal of achieving extraordinary equity returns.
Broader perspectives on leverage
More generally, leveraging can refer to making better use of any existing assets or opportunities, or improving a negotiating position. These dimensions of leverage can be critical in your career development, especially combined with the technical aspects we’ve discussed together above.
Thank you for leveraging your treasury skills by reading this article. Please make use of the ACT’s growing library of relevant resources, qualifications and practical training, and continue to schedule this important work into your diary.
Author: Doug Williamson FCT
Other resources
Practical reporting for treasurers https://learning.treasurers.org/resources/practical-reporting-for-treasurers
Sustainability in practice for treasury https://learning.treasurers.org/resources/sustainability-practice-treasury