Leverage

AAA

DEFINITION of 'Leverage'

1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.

INVESTOPEDIA EXPLAINS 'Leverage'

1. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft (MSFT) stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.

2. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders.

Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.

Go further with your knowledge of Leverage. Read Leverage: What It Is And How It Works

VIDEO

RELATED TERMS
  1. Borrowed Capital

    Funds borrowed from either individuals or institutions. Borrowed ...
  2. Overleveraged

    Occurs when a business is carrying too much debt, and is unable ...
  3. Derivatives Time Bomb

    A possibile situation where the financial markets plunge into ...
  4. Leveraged ETF

    An exchange-traded fund (ETF) that uses financial derivatives ...
  5. Hedge Fund

    An aggressively managed portfolio of investments that uses advanced ...
  6. Futures

    A financial contract obligating the buyer to purchase an asset ...
Related Articles
  1. Investing Basics

    What is the difference between the gearing ratio and the debt-to-equity ratio?

    Dive deeper into gearing ratios: what are they, how are they used and why the debt to equity ratio is one of the most popular analytical gearing tools.
  2.  Here we take a look at how you can evaluate whether the debt will affect your investment.
    Investing Basics

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  3.  if used properly, options can have less risk than an equivalent position in a stock
    Options & Futures

    Reducing Risk With Options

    If you want to use leverage to your advantage, you must know how many contracts to buy.
  4. Mutual Funds & ETFs

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  5. Options & Futures

    Leveraged Investment Showdown

    Margin loans, futures and ETF options can all mean better returns, but which one should you pick?
  6. Forex Education

    Forex Leverage: A Double-Edged Sword

    Find out how this flexible and customizable tool magnifies both gains and losses.
  7. Mutual Funds & ETFs

    Dissecting Leveraged ETF Returns

    These funds are a relatively new product to most investors, but they could be what you need for increased returns.
  8. Mutual Funds & ETFs

    Why Leveraged ETFs Don't Always Boost Returns

    These ETFs don't always provide the returns you expect. Find out why this happens, and what you can do about it.
  9. Options & Futures

    What Can Traders Learn From Investors?

    Discover tips from a long-term strategy that can help you make better short-term trades.
  10. Options & Futures

    Leveraged ETFs: Are They Right For You?

    This specialty vehicle offers dramatic results, but can also magnify risk.

You May Also Like

Hot Definitions
  1. Commodity

    1. A basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often ...
  2. Deferred Revenue

    Advance payments or unearned revenue, recorded on the recipient's balance sheet as a liability, until the services have been ...
  3. Multinational Corporation - MNC

    A corporation that has its facilities and other assets in at least one country other than its home country. Such companies ...
  4. SWOT Analysis

    A tool that identifies the strengths, weaknesses, opportunities and threats of an organization. Specifically, SWOT is a basic, ...
  5. Simple Interest

    A quick method of calculating the interest charge on a loan. Simple interest is determined by multiplying the interest rate ...
  6. Special Administrative Region - SAR

    Unique geographical areas with a high degree of autonomy set up by the People's Republic of China. The Special Administrative ...
Trading Center