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Leverage Definition

In finance, Leverage can be defined as any strategy that involves borrowing funds to purchase goods, with the expectation that the future profit will be higher than the amount borrowed. Financial Leverage is the use of borrowing capital to serve as a financing source to invest in order to increase the company's assets base and earn profits from risk capital. Leverage is a strategy for investing that consists that involves borrowing money, specifically the use of different types of financial instruments, or capital borrowed--to enhance the potential returns from an investment.

Leverage Definition

Understanding Financial Leverage

Leverage is the process of using the concept of debt (borrowed capital) for the purpose of completing an investment or plan. The result is that it increases the potential return from an investment or project. However, Leverage can also increase the possibility of risk of a negative outcome when the investment fails to work out as expected. If one describes an entity, property, and/or investment to be "highly leveraged," it indicates that the item is in higher capital than equity.

Leverage is a concept utilized by both investors and businesses. Investors use Leverage to drastically boost the return that can be earned from an investment. They leverage their investments by making use of various instruments, such as Options, Futures, and margin accounts. Businesses can leverage their resources to finance their investments. This means that instead of issuing shares for capital raising, businesses can utilize credit financing to fund businesses in order to boost shareholder value.

Investors who aren't confident in using Leverage directly can avail of several options to gain Leverage in indirect ways. Investors can choose to invest in businesses that employ Leverage in the operation of their company to fund or expand their operations without increasing the amount they invest.

Calculating Leverage

There's a whole array of leverage financial ratios to determine the amount of Leverage a business is taking on to increase profits. Several common leverage ratios are listed below.

1. Debt-to-Assets Ratio

Debt-to-Assets Ratio = Total Debt / Total Assets

A company can evaluate its Leverage by looking at how much of its assets were bought with the debt. A business can reduce the Ratio of debt to assets by 1 to calculate an equity-to-assets percentage. If the Ratio of debt to assets is high, the company relies on Leverage to fund its assets.

2. Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Debt / Total Equity

Instead of focusing on what the company has, the company can determine Leverage by looking at the way assets were financed. The debt-to-equity Ratio can be used to measure those loans the firm has taken in relation to the amount of money it has raised from shareholders or private investors.

A debt-to-equity ratio equal to 1 means that the total liabilities equal the shareholder's equity. But this doesn't indicate that a company is leveraged. Every industry or company is likely to operate in a certain way, which could result in a higher than or lower percentage. For example, young tech companies might struggle to obtain financing and frequently look at private equity investors. So, a debt-to-equity ratio of .5 might still be too high in this particular industry.

3. Debt-to-EBITDA Ratio

Debt-to-EBITDA = Total Debt / Earnings Before Interest, Taxes, Depreciation, and Amortization

A business can also evaluate its debt with the amount of income it generates during the course of a particular time. It is important for the company to be aware of the amount of debt in relation to operating earnings which is manageable. Therefore, it is normal to utilize EBITDA rather than net earnings. A business with an excessive debt-to-EBITDA ratio is carrying a significant burden compared to the profits the company earns. The higher the Ratio of debt to EBITDA, the greater Leverage a business is carrying.

Equity Multiplier

Equity Multiplier = Total Assets / Total Equity

While debt isn't directly included as part of the equity multiplier calculation, it's part of the total value of assets as well as total equity. Each one is directly linked to total debt. The equity multiplier tries to determine the ownership percentage of a business by looking at the way assets are funded. A company that has an equity multiplier that is low has funded a significant part of its assets using equity, which means they're not overly leveraged.

DuPont's research employs analysis of the "equity multiplier" to measure the financial Leverage. It is possible to calculate the equity multiplier by subdividing the assets of a business's total by the total equity. Once this is done, one multiplies the financial Leverage by the turnover of the entire asset and profit margin to generate the equity's return.

For instance, if a publicly traded company has assets totaling $500 million and equity of shareholders worth $250 million, the equity multiplier will be 2.0 ($500 million/$ 250 million). This indicates that the company has funded half of its assets with equity. Therefore, larger equity multipliers indicate more Leverage in financial terms.

Degree of Financial Leverage (DFL)

Degree of Financial Leverage = % Change in Earnings Per Share / % Change in EBIT

Fundamental analysis is based on the amount of Leverage in financial transactions. The amount of Leverage is determined by multiplying the percentage change in earnings per share (EPS) by the percentage change in earnings before tax and interest (EBIT) in a particular time interval. The purpose of calculating DFL is to determine the degree to which a company's earnings per share depend on changes in operating income. A higher percentage will indicate an increased degree of Leverage. A company that has an extremely high DFL will probably have higher volatility in earnings.

Consumer Leverage Ratio

Consumer Leverage = Total Household Debt / Disposable Income

These formulas are employed by companies that are using Leverage to run their business. However, families may also benefit from Leverage. By borrowing money and utilizing personal income to pay for interest costs, households can also make use of Leverage.

Consumer leverage is determined by dividing the debt of a household by its disposable income. Households that have higher consumer leverage are in high levels of debt in relation to the amount they earn and thus are heavily leveraged. The consumer may face difficulties getting loans if their Leverage increases to a high level. For instance, lenders typically restrict the Ratio of their debt to income when homeowners are seeking mortgage loans.

Financial ratios are the ones that have the most significance when they are compared over time or against competitors. Take care when analyzing the leverage ratios of different companies because different industries may warrant different financial compositions.

Advantages of Leverage-

  1. Leverage is used by traders and investors principally to increase profits. Profits from winners can be exponentially profitable when the initially invested capital is multiplied with more capital upfront. Additionally, Leverage lets you access higher-end investment options which you might not have the ability to access with a lesser amount of capital.
  2. Leverage is a viable option in short-term, risk-free situations in which high levels of capital are required. In the context of buyouts or acquisitions, the growing business might have a short-term requirement for capital that could provide a solid mid- to long-term growth opportunity. In contrast to using extra capital to take on risky ventures, Leverage allows companies to seize opportunities at optimal timing with the goal of reversing their leveraged position rapidly.
  3. Investments that are successful are amplified and can result in a huge profit.
  4. Provides investors with more opportunities to gain access to more costly trading opportunities (reduces the barriers to entry).
  5. It can be utilized strategically by businesses that require short-term financing for buyouts or acquisitions.

Limitations of Leverage-

  1. If the gains of winning investments are amplified, then so are the losses. The use of Leverage could result in a greater risk of downside which can result in losses higher than your original capitalization. In addition, brokers and contract traders charge you fees, premiums, and margin rates. If you do lose your trade, you'll be liable for additional charges.
  2. Leverage can also have the negative of being difficult to understand. Investors need to take note of their financial status and the risk they take when entering a leveraged position. This might require extra focus on one's portfolio as well as the additional investment of capital in the event that their trading account does not contain an adequate amount of equity to meet the broker's requirements.
  3. The losses from investments can be amplified, possibly resulting in massive losses.
  4. Much more expensive than other kinds of trading
  5. Results in a rise in fees, margin rates, and contract premiums, regardless of the performance of the transaction.
  6. More complex in the area of trading that could require additional time and capital based on the needs of your portfolio.

Leverage Vs. Margin

Margin is a particular kind of Leverage that makes use of the existing securities or cash position in the form of collateral, which can increase the purchasing capacity within the financial markets. Margin lets you get money from a broker in exchange for an interest rate fixed to purchase options, securities, and options or futures contracts with the expectation of receiving a substantial increase in returns.

The margin can be used to build Leverage, which increases your purchasing capability by the marginal amount. For instance, if the collateral needed to buy $10,000 worth of securities is $1,000, you'd have a 1:10 margin (and 10x Leverage).

Example of Leverage

The company was founded with a $5 million loan from investors. The equity of the company is $5 million. This is the amount of money the business can utilize to run its operations. If the business uses the financing method of debt through borrowing 20 million dollars, the company has $25 million available to put into business activities and greater potential to create value for its shareholders.

A car manufacturer, for instance, might take a loan to construct an entirely new facility. The new plant would allow the company to expand the number of vehicles it makes and boost its profits. Instead of having to rely on just the $5 million raised by shareholders, it currently has five times that amount to spend on growth for the company.

These kinds of leveraged positions are common in the financial market. For instance, Apple issued $4.7 billion of Green Bonds for the third time in March 2022.3. With the help of debt funding, Apple is able to increase recycling and manufacturing that is a low carbon and the use of carbon-free aluminum. If the approach results in more profits than the cost that the bonds cost, Apple would have successfully increased its investment.

What is a Good Financial Leverage Ratio?

Every company has a different opinion on what constitutes a great finance leverage ratio. Some investors are more cautious and would prefer to lower their debt. Some investors view Leverage as the chance to gain access to capital that can boost their earnings.

A ratio of equity to debt higher than 1 indicates that the company has decided to borrow more debt rather than financing through shareholders. Although this isn't necessarily a problem however, it does mean that the business may be more at risk from inflexible debt obligations. The business could also face higher costs when borrowing in the event of a loan request at some point in the future. But, the majority of profits are kept by the owners since their share of the business is not dispersed over a vast number of shareholders.

Why is Financial Leverage Important?

Financial Leverage is crucial because it opens up opportunities for investors. There is risk associated with this opportunity, and it is recommended that investors who are new get a knowledge of the concept of Leverage and the potential risks prior to committing to levered positions. Financial Leverage can be utilized in a strategic way to position portfolios to benefit from winners and to suffer more if investments go down.

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