What Is Leverage

Leverage is the result of using borrowed capital as a source of funding in order to grow the firm's asset base , and yield profits from risk capital. Leverage is an investment method that involves borrowing money, specifically the use of different types of financial instruments, and borrowing capital--to enhance the potential returns from an investment.

Leverage may also refer to what amount credit that a company makes to fund assets.

KEY TAKEAWAYS

Leverage is the process of making usage of borrowing (borrowed cash) to increase the return on projects or investments.

Investors leverage leverage to increase their purchasing power on the market.

Businesses use leverage in order to fund their investments instead of selling stocks to raise capital businesses can make use of the leverage of debt to fund businesses in order to boost shareholder value.

Understanding Leverage

Leverage is the process of using borrowing (borrowed capital) to fund an investment or undertake a project. It is a way to increase the chance of earning returns from an investment or project. In the same way leverage can also increase the possibility of negative risk when the investment doesn't work out as expected. If someone refers to the property, company or an investment, it is referred to as "highly dependent," this means the it is more in leverage than capital. (Hassanworld)

Leverage is a concept employed by both investors as well as businesses. Investors leverage leverage to drastically improve the return that could be earned from an investment. They leverage their investments making use of various instruments, such as options as well as futures and margin accounts. Businesses can leverage lean to pay for their asset. That is, instead of releasing stock in order to increase capital investment, businesses may use credit financing to fund the business in order to boost shareholder value.

Investors who do not feel confident in using leverage directly can avail many options to gain leverage in indirect ways. You can make investments in firms using leverage in the process of their business to fund or expand operations without increasing the amount they invest.

Leverage increases the potential return similar to the lever is able to increase the strength of a person lifting heavy objects.

Special Considerations

Through the analysis of balance sheets through balance sheet analysis, investors can look at the equity and debt balances in the books of different companies, and then invest in businesses that use leverage to the benefit of their business. Statisticians like returns to equity (ROE), debt to equity (D/E) as well as the return of capital employed (ROCE) help investors to determine how companies use capital and the extent of it they have borrowed.

To be able to evaluate these numbers properly it is essential to be aware how leverage is available in a variety of types, such as financial, operational and combined.

Fundamental analysis is based on the level of leverage in operating. You can determine the level of leverage in operating by dividing the change in percentage of the company's earnings per share (EPS) by the percent change in its earnings before tax and interest (EBIT) over a time.

Similar to this, one could determine the level of leverage in operating by dividing the company's EBIT times EBIT plus interest expenses. A higher percentage of operating leverage indicates an increase in the volatility in the company's EPS.

DuPont study employs an "equity multiplier" to determine the financial leverage. You can determine the equity multiplier simply by dividing the assets of a business' total by the equity total. After calculating, one can multiply the financial leverage with total turnover of assets and profit margin to calculate the equity return. For instance that if an publicly traded company is worth $500 million and equity in the shareholders is valued at $250 million the equity multiplier will be 2.0 ($500 million/$250 millions). This means that the business has been able to finance half its assets with equity. Thus, larger equity multipliers indicate more leverage in financial terms.

If using spreadsheets to conduct basic analysis isn't your style then you could consider purchasing the mutual fund or exchange traded funds (ETFs) which leverage. With these funds you can outsource the investment and research decisions to professionals.

Leverage Versus. Margin

Margin is a specific kind of leverage that makes use of the existing securities or cash position in the form of collateral which can increase the purchasing ability in the financial market. Margin lets you get the money of a broker at an annual fixed rate of interest to purchase options, securities as well as the futures contracts with the hope of earning substantial profits. 1

It is possible to use margin to increase leverage, thereby improving your buying power to the maximum margin you can afford. For example for instance, if the collateral requirement to purchase $10,000 worth of securities is $1,000, it would be an 1:10 margin (and 10x leverage).

Disadvantages of Leverage

Leverage is an incredibly multi-faceted, complicated instrument. It sounds like a great idea but in actual fact leverage can yield profits however the opposite is also the case. Leverage can increase gains as well aslosses. If an investor leverages to invest and the investment is subsequently redirected in the direction of the investor the loss will be more than it would've been if they had used leverage to make the investment.

This is why leverage is usually avoided by investors who are new to the market until they gain more experience. In the world of business it is possible for a business to use leverage to increase shareholder wealth. However, when it fails to accomplish this the cost of interest and risk of credit default will destroy shareholder value. (Hassanworld)

Example of Leverage

The company was founded by a $5 million loan by investors. The equity of the business is $5 million. This is the cash the company is able to use for its operations. If the company makes use of credit financing through borrowing 20 million, it has $25 million available to put into business activities, and an opportunity to boost the value of its shareholders.

A car manufacturer, for instance can take out a loan to construct the new factory. The new facility would allow the automaker to expand the amount of vehicles they produce and also increase its profit.

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