What is Leverage?
Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.
Leverage is the use of debt (borrowed capital) in order to undertake investment or project. The result is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out. When one refers to a company, property, or investment as "highly leveraged," it means that item has more debt than equity.
The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments, including options, futures, and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
Investors who are not comfortable using leverage directly have a variety of ways to access leverage indirectly. They can invest in companies that use leverage in the normal course of their business to finance or expand operations—without increasing their outlay.
Leverage amplifies possible returns, just like a lever can be used to amplify one's strength when moving a heavyweight.
Through balance sheet analysis, investors can study the debt and equity on the books of various firms and can invest in companies that put leverage to work on behalf of their businesses. Statistics such as return on equity (ROE), debt to equity (D/E), and return on capital employed (ROCE) help investors determine how companies deploy capital and how much of that capital companies have borrowed. To properly evaluate these statistics, it is important to keep in mind that leverage comes in several varieties, including operating, financial, and combined leverage.
Fundamental analysis uses the degree of operating leverage. One can calculate the degree of operating leverage by dividing the percentage change of a company's earnings per share (EPS) by its percentage change in its earnings before interest and taxes (EBIT) over a period. Similarly, one could calculate the degree of operating leverage by dividing a company's EBIT by EBIT less interest expense. A higher degree of operating leverage shows a higher level of volatility in a company's EPS.
DuPont analysis uses the "equity multiplier" to measure financial leverage. One can calculate the equity multiplier by dividing a firm's total assets by its total equity. Once figured, one multiplies the financial leverage with the total asset turnover and the profit margin to produce the return on equity. For example, if a publicly-traded company has total assets valued at $500 million and shareholder equity valued at $250 million, then the equity multiplier is 2.0 ($500 million / $250 million). This shows the company has financed half its total assets by equity. Hence, larger equity multipliers suggest more financial leverage.
If reading spreadsheets and conducting fundamental analysis is not your cup of tea, you can purchase mutual funds or exchange-traded funds (ETFs) that use leverage. By using these vehicles, you can delegate the research and investment decisions to experts.
Leverage vs. Margin
Although interconnected—since both involve borrowing—leverage and margin are not the same. Leverage refers to taking on debt, while margin is debt or borrowed money a firm uses to invest in other financial instruments.
A margin account allows you to borrow money from a broker for a fixed interest rate to purchase securities, options, or futures contracts in the anticipation of receiving substantially high returns. You can use margin to create leverage.
Disadvantages of Leverage
Leverage is a multi-faceted, complex tool. The theory sounds great, and in reality, the use of leverage can be profitable, but the reverse is also true. Leverage magnifies both gains and losses. If an investor uses leverage to make an investment and the investment moves against the investor, their loss is much greater than it would've been if they have not leveraged the investment.
For this reason, leverage should often be avoided by first-time investors until they get more experience under their belts. In the business world, a company can use leverage to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroy shareholder value.
Example of Leverage
A company was formed with a $5 million investment from investors, where the equity in the company is $5 million—this is the money the company can use to operate. If the company uses debt financing by borrowing $20 million, it now has $25 million to invest in business operations and more opportunity to increase value for shareholders.
An automaker, for example, could borrow money to build a new factory. The new factory would enable the automaker to increase the number of cars it produces and increase profits.