What is leverage?
Leverage results from the use of borrowed capital as a source of finance during the investment to broaden the company’s asset base and generate returns on venture capital. Leverage is an investment strategy of using borrowed money – in particular, the use of various financial instruments or borrowed capital – to increase the potential return on an investment. Leverage can also refer to the amount of debt a business uses to finance assets. When you describe a business, asset, or investment as “highly leveraged,” it means that this item has more debt than equity.
Leverage amplifies the possible returns, just as a lever can be used to amplify its force when moving a heavy vehicle.
How leverage works
Leverage is the use of debt (borrowed capital) to undertake an investment or project. The result is to multiply the potential returns of a project. At the same time, the leverage will also multiply the potential downside risk in the event that the investment is not made.
The concept of leverage is used by both investors and businesses. Investors use leverage to significantly increase the returns that can be provided on an investment. They optimize their investments by using various instruments which include options, futures and margin accounts. Businesses can use leverage to finance their assets. In other words, instead of issuing shares to raise capital, companies can use debt financing to invest in business operations to increase shareholder value.
Investors who are not comfortable using leverage directly have a variety of ways to access leverage indirectly. They can invest in companies that use leverage in the normal course of business to finance or expand their operations, without increasing their expenses.
Key points to remember
- Leverage refers to the use of debt (borrowed funds) to boost the returns on an investment or project.
- Investors use leverage to multiply their purchasing power in the market.
- Companies use leverage to finance their assets: instead of issuing stocks to raise capital, companies can use debt to invest in business operations to increase shareholder value.
The difference between leverage and margin
Although interconnected – since the two involve borrowing – the leverage and margin are not the same. Leverage refers to debt, while margin is debt or borrowed money that a company uses to invest in other financial instruments. A margin account allows you to borrow money from a broker at a fixed interest rate to buy securities, options or futures in order to receive substantially high returns.
You can use the margin to create leverage.
Example of leverage
A company formed with an investment of $ 5 million from investors, the equity of the company is $ 5 million; it’s the money the business can use to run. If the company uses debt financing by borrowing $ 20 million, it now has $ 25 million to invest in business operations and more opportunities to increase shareholder value. An automaker, for example, could borrow money to build a new factory. The new plant would allow the automaker to increase the number of cars produced and increase profits.
Through balance sheet analysis, investors can study debt and equity on the books of various companies and can invest in companies that leverage to work on behalf of their companies. Statistics such as return on equity, debt to equity, and return on capital employed help investors determine how companies are deploying capital and how much of it has been borrowed. To properly assess these statistics, it is important to keep in mind that leverage comes in several variations, including operational, financial and combined leverage.
Fundamental analysis uses the degree of operating leverage. The degree of operating leverage can be calculated by dividing the percentage change in earnings per share of a business by its percentage change in earnings before interest and taxes over a period. Similarly, the degree of operating leverage could be calculated by dividing the EBIT of a business by its EBIT less its interest expense. A higher level of operating leverage shows a higher level of volatility in a company’s EPS.
DuPont analysis uses the “equity multiplier” to measure financial leverage. The equity multiplier can be calculated by dividing the total assets of a business by its total equity. Once figured, we multiply the financial leverage by the total turnover of the assets and the profit margin to produce the return on equity. For example, if a publicly traded company has total assets valued at $ 500 million and equity valued at $ 250 million, the equity multiplier is 2.0 ($ 500 million / $ 250 million ). This shows that the company financed half of its total assets with equity. Therefore, larger equity multipliers suggest more leverage.
If reading spreadsheets and performing fundamental analysis is not your cup of tea, you can buy mutual funds or exchange-traded funds that use leverage. By using these vehicles, you can delegate research and investment decisions to experts.
The disadvantages of leverage
Leverage is a complex, multifaceted tool. The theory sounds excellent, and in reality the use of leverage can be profitable, but the reverse is also true. Leverage amplifies both gains and losses. If an investor uses leverage to make an investment and the investment moves against the investor, his loss is much greater than he would have been had he not taken advantage of the ‘investment.
In the business world, a business can use leverage to generate wealth for shareholders, but if it does not, interest expense and the credit risk of default destroy shareholder value. .