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. Leveraged ETF

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

    An aggressively managed portfolio of investments that uses advanced ...
  5. Leveraged Buyout - LBO

    The acquisition of another company using a significant amount ...
  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. 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. 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

COMPANIES IN THIS ARTICLE
Hot Definitions
  1. Multiplier Effect

    The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends ...
  2. Command Economy

    A system where the government, rather than the free market, determines what goods should be produced, how much should be ...
  3. Prospectus

    A formal legal document, which is required by and filed with the Securities and Exchange Commission, that provides details ...
  4. Treasury Bond - T-Bond

    A marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest ...
  5. Weight Of Ice, Snow Or Sleet Insurance

    Financial protection against damage caused to property by winter weather specifically, damage caused if a roof caves in because ...
  6. Weather Insurance

    A type of protection against a financial loss that may be incurred because of rain, snow, storms, wind, fog, undesirable ...
Trading Center