A:

In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their assets. However, using leverage does not guarantee success, and the possibility of excessive losses is greatly enhanced in highly leveraged positions. For companies, there are two types of leverage that can be used: operating leverage and financial leverage.

Operating leverage relates to the result of different combinations of fixed costs and variable costs. Specifically, the ratio of fixed and variable costs that a company uses determines the amount of operating leverage employed. A company with a greater ratio of fixed to variable costs is said to be using more operating leverage. If a company's variable costs are higher than its fixed costs, the company is said to be using less operating leverage. The way that a business makes sales is also a factor in how much leverage it employs. A firm with few sales and high margins is said to be highly leveraged. On the other hand, a firm with a high volume of sales and lower margins is said to be less leveraged.

Financial leverage arises when a firm decides to finance a majority of its assets by taking on debt. Firms do this when they are unable to raise enough capital by issuing shares in the market to meet their business needs. When a firm takes on debt, it becomes a liability on which it must pay interest. A company will only take on significant amounts of debt when it believes that return on assets (ROA) will be higher than the interest on the loan.

A firm that operates with both high operating and financial leverage makes for a risky investment. A high operating leverage means that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales. If a future sales forecast is slightly higher than what actually occurs, this could lead to a huge difference between actual and budgeted cash flow, which will greatly affect a firm's future operating ability. The biggest risk that arises from high financial leverage occurs when a company's ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.

To learn more, see Introduction To Fundamental Analysis, Understanding The Subtleties Of ROA Vs. ROE and When Companies Borrow Money.

RELATED FAQS
  1. Besides operating leverage, what are other important forms of leverage for businesses?

    Learn about what other forms of leverage exist for businesses besides operational leverage, and the primary leverage metrics ... Read Answer >>
  2. How can a firm bring down its operating leverage?

    Discover how to determine a company's operating leverage and how this metric can be helpful to analysts and investors when ... Read Answer >>
  3. How does leverage work in the forex market?

    Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments ... Read Answer >>
  4. Can mutual funds use leverage?

    Learn about what types of mutual funds use leverage, how leverage can increase returns and what restrictions are in place ... Read Answer >>
  5. What is "leverage" as it is used in closed-end funds?

    A distinguishing feature of closed-end funds is their ability to use borrowing as a method to leverage their assets. An ideal ... Read Answer >>
Related Articles
  1. Trading

    The Basics of Forex Leveraging

    A closer look at the controversial topic of leverage in forex trading.
  2. Personal Finance

    Borrowing Smart In A Debt-Filled World

    Leveraging your money can have many perks, but it's not always the smartest financial plan.
  3. Investing

    The Hidden Danger of Leveraged ETFs

    Leveraged ETFs pose several dangers for retail investors tempted by potential high returns in a short period of time.
  4. Financial Advisor

    Why Leveraged ETFs Are Not a Long-Term Bet

    Leveraged ETFs aren't for the average investor. They can, however, present significant upside potential for the right type of trader.
  5. Trading

    Adding Leverage To Your Forex Trading

    The use of margin to trade in the foreign exchange market can magnify profit opportunities.
  6. Managing Wealth

    Leveraging Leverage For Bigger Profits

    Leverage is like fire. Find out how to use it to heat up your investing without burning your portfolio.
  7. Financial Advisor

    Understanding The Leverage Ratio

    Learn more on how the leverage ratio is used to calculate a company's ability to meet financial obligations and how changes in output will affect operating income.
  8. Investing

    Leveraged ETFs: Are They Safe? (BLK, WETF)

    Discover why leveraged ETFs are not necessarily a doomsday product. Learn the opinions of BlackRock’s Larry Fink and other industry experts on these products.
  9. Financial Advisor

    Introduction to Leveraged ETFs

    Leveraged exchange-traded funds have appeared that are designed to move either conversely or inversely to their underlying benchmark, which may be either a financial index or a specific segment ...
RELATED TERMS
  1. Leverage

    The use of various financial instruments or borrowed capital, ...
  2. Leverage Build Up

    The accumulation of additional debt to enter a position that ...
  3. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  4. Maximum Leverage

    The maximum size of a trading position permitted through a leveraged ...
  5. Leveraged Loan

    Loans extended to companies or individuals that already have ...
  6. Net Leverage

    The sum of an insurance company’s net premiums written ratio ...
Hot Definitions
  1. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  2. Absolute Advantage

    The ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost ...
  3. Nonce

    Nonce is a number added to a hashed block, that, when rehashed, meets the difficulty level restrictions.
  4. Coupon

    The annual interest rate paid on a bond, expressed as a percentage of the face value. It is also referred to as the "coupon ...
  5. Socially Responsible Investment - SRI

    Socially responsible investing looks for investments that are considered socially conscious because of the nature of the ...
  6. Letter Of Credit

    A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. ...
Trading Center