Takeover & Underleveraged Firm

Underleveraged Firm:

"Describing a company with too little debt. "

http://financial-dictionary.thefreedictionary.com/Underleveraged

"Of, relating to, or being a firm that has insufficient debt in its capital structure. Because bond interest is deductible for tax purposes and is generally fixed in amount for a long period of time, some use of debt can often result in a larger return on the owners' investment. Whether a company is underleveraged is usually a matter of opinion. "

http://business.yourdictionary.com/underleveraged

Financial Leverage:

Before discussing about "underleveraged", I have to familiar with what's financial leverage:

1. Financial leverage ratios measure the funds supplied by owners (equity) as compared with the financing provided by the firm‘s creditors (debt).
- i.e. Equity vs. Debt = Financial Leverage Ratios

2. Financial leverage is the use of debt to magnify return on equity (ROE) to shareholders.
3. Equity, or owner-supplied funds, provide a margin of safety for creditors. Thus, the less equity, the more the risks of the enterprise to the creditors.

4. To understand financial leverage, I need to understand ratios between Debt to Total Assets and Debt to Equity

Debt Ratio - Debt to Total Assets: Indicates the level of reliance of debt to finance its assets. To determine whether the ratio indicating of its good performance, we have to compare to the industrial average and the historical trend of the company. If the debt ratio is closing to the average, the performance of the company is improving, otherwise is worsening.

Debt to Equity Ratio - Total Debt to Total Equity: Indicates the level of financial leverage. It compares the amount of money borrowed from creditors to the amount of shareholder’s investment made within a firm.


Illustration of overleveraged and underleveraged:


Overleveraged:
- The problem of overleverage occurs when a firm has overborrowed debt from a bank (or other sources) on a consistent basis;
- As a result, firm has a higher Debt to Equity Ratio;
- Using debt to run a firm is a common practice, however, sometimes there is an over-reliance on debt;
- Over-reliance on debt can be a factor in hurting the company’s bottom line;


Underleveraged:
- The problem of underleverage arises when a firm has raised majority of its capital through stocks;
-As a result, firm has a very low Debt to Equity Ratio;
-With higher equity the firm has to improve its performance to keep the shareholders happy;
-If firm pays dividends, it has to constantly allocate a portion of its profits towards dividends payable to shareholders;