What is leverage?

Definition

Leverage refers to the use of borrowed funds or debt to amplify the potential returns or risks of an investment or financial transaction. It involves using borrowed capital to finance an investment or business activity with the aim of increasing the potential for higher returns on equity.

Leverage can be a powerful tool for increasing profits, but it also comes with increased risk.

Here are two common forms of leverage:

1. Financial leverage: Financial leverage involves borrowing money to invest in assets or operations. In business, this often takes the form of loans, bonds, or lines of credit. By using debt financing, a company can amplify its returns if the return on investment (ROI) from the borrowed capital exceeds the cost of borrowing (interest rate). However, it also increases the risk because if the ROI is lower than the cost of borrowing, it can lead to financial losses and financial distress.

2. Operating leverage: Operating leverage refers to the use of fixed operating costs, such as rent, salaries, and depreciation, to magnify the impact of changes in sales or revenue on a company’s profits. Companies with high operating leverage have a higher proportion of fixed costs in their cost structure. When revenue increases, these companies can experience a significant increase in profits. However, during periods of declining revenue, they can also face more significant losses.

Leverage can enhance returns in a rising market but can lead to substantial losses in a declining market or when investments underperform. It’s important to manage leverage carefully and consider the associated risks. Excessive leverage can lead to financial instability, especially if a business or investor cannot meet their debt obligations.

Financial professionals and investors often use metrics like the debt-to-equity ratio to assess the level of leverage in a company or investment portfolio. Effective leverage management involves balancing the potential for higher returns with the associated risks to ensure financial stability and sustainability.

Example of leverage

Let’s consider a scenario where an individual uses leverage to invest in real estate. John is interested in real estate investment but has limited personal funds. He identifies a property worth $200,000 that he believes will appreciate in value over time.

Instead of using all his savings, John decides to apply leverage by taking out a mortgage. He approaches a bank and secures a mortgage loan of $150,000 with an interest rate of 4% per annum. This means that he only has to invest $50,000 of his own money as a down payment.

The financial leverage ratio can be calculated using the following formula:

Financial leverage ratio = Total asset value / Equity investment

Financial leverage ratio = $200,000 / $50,000 = 4

This means that John is leveraging his investment by a factor of 4.