Understanding the concept of ‘Double Leverage’
One of the most important things that measure the health of company’s finances is the degree to which the assets of the company are leveraged. Reserve Bank of India (RBI) has highlighted the effect of ‘double leveraging’ over the financial health of the corporate house.
What is ‘Double Leverage’?
The concept can be easily defined as a scenario where a debt raised by the holding company on its books is passed on as equity capital in the related subsidiaries. In case further debt is raised by the subsidiary, the leverage will only increase as the now the debt component gets added to the equity part of the capital. Infrastructure or realty sector witnesses various such examples.
“From lenders’ perspective, a debt-to-equity ratio of 2:1 at the holding company level could transform into a leverage of 8:1 at the SPV level. While there could be some merit in such practices, risk assessments by banks need to capture this effectively,” the banking regulator said in its Financial Stability Report.
Double leverage only increases associated risk of the lenders. For the reason most of the real estate projects are financed by debt, and with debt component seeping in through equity capital, the real debt-equity ratio becomes higher, thus posing risk to lenders.