What Is Leverage and How Does It Work?
When a company invests to develop its asset base and create returns on risk capital, it uses borrowed capital as a funding source. Leverage is an investment technique that involves leveraging borrowed money—specifically, various financial instruments or borrowed capital—to boost an investment’s potential return.
The amount of debt a company utilizes to finance assets is often referred to as leverage.
Important Points to Remember
- The use of debt (borrowed cash) to boost the returns on an investment or project is known as leverage.
- Leverage allows investors to increase their purchasing power in the market.
- Instead of issuing shares to raise capital, corporations might use debt to invest in business operations in an attempt to create shareholder value.
The use of debt (borrowed capital) to finance a venture or undertaking is known as leverage. As a result, the project’s potential returns are multiplied. Simultaneously, leverage increases the potential downside risk if the venture does not pan out. When a firm, property, or investment is referred to as “highly leveraged,” it suggests it has more debt than equity.
Both investors and businesses employ the idea of leverage. Investors utilize leverage to boost the amount of money they can make on a given investment. They use a variety of products to leverage their investments, including options, futures, and margin accounts. Leverage can be used to finance a company’s assets. To put it another way, instead of issuing shares to raise capital, businesses can use debt financing to invest in their operations in order to create shareholder value.
Investors that are hesitant to use leverage directly can use leverage indirectly in a variety of ways. They can invest in companies that utilize leverage to fund or grow operations in the usual course of business without increasing their outlay.
A lever can be used to enhance one’s strength when moving a large weight, and it can also be used to amplify prospective returns.
Particular Points to Consider
Investors can analyse the debt and equity on the records of various companies using balance sheet research and invest in companies that use leverage to their advantage. Return on equity (ROE), debt to equity (D/E), and return on capital employed (ROCE) are all statistics that help investors figure out how companies deploy capital and how much of that capital they have borrowed.
It’s vital to remember that leverage occurs in many forms, including operating, financial, and combined leverage, while evaluating these figures.
The degree of operating leverage is used in fundamental analysis. The degree of operating leverage may be calculated by dividing the change in a company’s earnings per share (EPS) by the change in earnings before interest and taxes (EBIT) over time.
Similarly, the degree of operating leverage can be calculated by dividing a company’s EBIT by EBIT less interest expense. A higher degree of operating leverage indicates that a company’s EPS is more volatile.
The “equity multiplier” is used in DuPont analysis to calculate financial leverage. The equity multiplier is calculated by dividing a company’s total assets by its total equity. To calculate the return on equity, multiply the financial leverage by the total asset turnover and the profit margin. The equity multiplier is 2.0 ($500 million / $250 million) in the case of a publicly traded business with total assets of $500 million and shareholder equity of $250 million. This indicates that the corporation has used equity to fund 50% of its total assets. As a result, higher equity multipliers imply more financial leverage.
If reading spreadsheets and performing basic analysis isn’t your thing, you can invest in leveraged mutual funds or exchange-traded funds (ETFs). You can delegate research and investment decisions to specialists by employing these vehicles.
Margin vs. Leverage
Margin is a sort of leverage that entails utilizing current cash or securities as collateral to improve one’s purchasing power in financial markets.
Margin permits you to borrow money from a broker at a fixed interest rate and use it to buy securities, options, or futures contracts in the hopes of making a lot of money.
As a result, you can utilize margin to increase your buying power by the marginable amount—for example, if the collateral necessary to buy $10,000 worth of stocks is $1,000, you’d have a 1:10 margin (and 10x leverage).
Leverage’s Negative Effects
Leverage is a multifaceted and intricate tool. The notion sounds fantastic, and using leverage can be advantageous in reality, but the opposite is also true. Both gains and losses are magnified when using leverage. If an investor utilizes leverage to make a purchase and the purchase goes against them, their loss is significantly larger than it would have been if they hadn’t leveraged the purchase.
As a result, first-time investors should avoid using leverage until they have more experience under their belts. A corporation can employ leverage to build shareholder wealth in the business sector, but if it fails to do so, interest expenditure and the danger of default diminish shareholder value.
Leverage in Action
A $5 million investment from investors resulted in a $5 million equity in the company, which is the money the company may use to run. If the company borrows $20 million in debt financing, it now has $25 million to invest in business operations and greater opportunities to generate shareholder value.
For example, an automaker could take out a loan to construct a new factory. The new factory would allow the company to increase production while also increasing earnings.