In short:
Financial leverage, typically just called leverage, is a term used to refer to the amount of debt financing a company is using. When a company borrows money to buy assets or expand its core business operations, they are using leverage.
Companies like to use leverage since it typically increases their returns, however, too much leverage and a company is “overextended” running the risk of default.
Key Points
- Leverage refers to the amount of debt a company is using.
- By using more leverage companies can typically increase their profits but this also increases their risk of default.
- Almost all companies employ some amount of leverage.
In-depth:
Understanding Leverage
Leverage refers to using borrowed money to buy assets or expand business operations. By using borrowed money, companies can expand their business by a higher degree than they otherwise would have by paying cash.
The reason for this is that borrowed money multiplies the effect of cash investments, hence the term leverage.
For example, instead of buying an asset for say $1, a company can use leverage to buy an asset worth $4 by borrowing the other $3 it doesn’t have. The result is that the company now owns a more valuable asset with the original $1 it had and reap greater benefits from the more valuable asset.
However, the term leverage doesn’t only apply when companies borrow money but when individuals borrow money. This means homeowners who buy a house via a mortgage are also using leverage, magnifying the purchasing power of their cash.
The biggest point to note about leverage, which applies to both companies and individuals, is that it multiplies both gains and losses.
Take the previous example above where a company bought $4 of assets using $1 of cash and $3 of debt. If the investment would “go bad”, meaning it losses value and they had to sell. The company’s loss could be greater than the $1 of cash they invested or larger than a 100% loss. On the other hand, if the value of the asset increases to $5, the company made a 100% gain on what would’ve only been a 25% gain if they used all cash.
Calculating Leverage Ratio
Calculating a leverage ratio is typically pretty straightforward via the formula below:
Leverage = Total Company Debt / Total Shareholders’ Equity
Or
Leverage = Amount Borrowed / Cash Invested
The appropriate leverage ratio for a company will depend on the industry the company is operating in. For example, companies who purchase real estate may have leverage ratios ranging from 3:1 to 5:1 whereas software companies may have much lower leverage ratios.
Benefits of Leverage
- Debt is often a cheaper source of financing than cash. By using leverage, companies or individuals can invest more of their money in higher returning projects.
- Magnifies returns by allowing a company to own more assets or expand their operations to a greater degree than what they could using only cash. This means small gains on the assets or operations are large gains when compared to the cash the company is putting in.
Drawbacks of Leverage
- Magnifies losses when the value of the asset or operations fall the losses are larger than if no leverage was used. Sometimes these losses can exceed 100%, meaning the company lost more than it initially invested.
- Increase risk from mandatory debt payments. When you use other people’s money they expect to be paid on time. If a company can’t come through on its debt payments, it risks default and forfeiting the asset over to the lender.
Leverage vs Margin
Margin is a special type of leverage that refers to money borrowed against cash or securities to buy more securities. Using margin, an investor would borrow money from a broker with a fixed interest rate to purchase more securities, futures contracts, or options. The investor’s objective by doing this is to earn a meaningfully higher return than the interest they are paying their broker.
For example, if an investor has $10,000 in a brokerage account and the broker has approved them for $20,000 buying power, they have a 2:1 margin ratio (or leverage of 2x ).