Leverage

What Is Leverage?

Leverage, also referred to as financial leverage, refers to the debts that a company incurs to fund its investments in other assets with the hope of raising huge profits.

The borrowed capital is usually used to undertake a project with a high potential for valuable returns. On the flip side, if things go wrong, there is an increased risk for huge losses.

Instead of listing stocks to finance potential purchases and expand the asset base of organizations, ‘leverage’ provides an option of using borrowed capital.

Investors can take advantage of leverage to strengthen their financial muscles as they attempt to increase shareholder value.

Deeper Definition

Leverage draws its meaning from a simple machine {a lever} that multiplies effort when attempting to move a load. Both investors and organizations heavily apply the concept of leverage.

For investors, returns on investments can be significantly increased or levered by using such instruments as margin accounts, futures, and so on.

On the other hand, companies use debt financing to invest in operations that further their business interests or are very profitable.

Investors who intend to milk the leverage opportunity- but not directly- can instead invest in companies that use leverage in the normal running of their business for funding or expansion.

The amount of debt incurred by a company relative to its assets is its debt-to-equity ratio, and lending agreements usually explicitly specify the limits on borrowing in the form of a maximum debt-to-equity ratio.

There is a special type of leverage known as a margin by which existing cash or securities function as collateral to increase the buying power of an investor.

Thus, a margin is used to gain leverage. For instance, a building worth $10,000 could be used to secure $50,000 worth of investments in a 1:5 margin.

Leverage is advised to be used by experienced investors, especially as the interest rates and credit risk of default could be harmful to the overall valuation of the stakeholders.

Leverage Example

Suppose a producer of building raw materials chooses to expand the plant and needs capital to fund it. In that case, such an individual might decide to borrow money that serves as leverage and, if successful, pay off the debt with considerable returns to spare.