What is Reverse Leverage?

Reverse leverage occurs when the proceeds from an investment are lower than the cost of funds of a business. In this situation, a business should unwind the investment and pay back the associated funds; otherwise, the firm will continue to experience negative cash flows that could eventually lead to its demise. During periods of spiking interest rates, it is especially critical to review whether reverse leverage is occurring.

Characteristics of Reverse Leverage

The following are key characteristics of a reverse leverage situation:

Negative returns. The cost of borrowing exceeds the returns generated by the investment.
Erosion of equity. When returns on investments fail to cover debt servicing, the shortfall must be covered by equity or additional resources, leading to potential financial strain.
Cash flow strain. High leverage typically involves fixed obligations such as interest payments. If the investment fails to generate sufficient cash flow, it can result in liquidity problems. This may lead to a default or forced asset sales.
Risk of insolvency. Persistent reverse leverage situations can lead to bankruptcy or insolvency, particularly if the entity is unable to restructure its debt or improve its returns.

Example of Reverse Leverage

David believes that he can generate an excellent return on investment by purchasing a manufacturing company. To do so, he takes on a loan that has a net after-tax cost of 8%. After one year, he finds that the actual net after-tax return on his purchase of the manufacturing company is just 3%. Since he is generating a negative return of 5% on his investment, David has experienced negative leverage.