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. When one refers to a company, property or investment as "highly leveraged," it means that item has more debt than equity.

BREAKING DOWN 'Leverage'

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.

The Difference Between Leverage and 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.

Example of Leverage

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 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.

Leverage Formulas

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, debt to equity and return on capital employed 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 by its percentage change in its earnings before interest and taxes over a period. Similarly, one could calculate the degree of operating leverage by dividing a company's EBIT by its EBIT less its 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 that use leverage. By using these vehicles, you can delegate the research and investment decisions to experts.

Downside 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. (For more on this view, see Forex Leverage: A Double-Edged Sword.) Leverage magnifies both gains and losses. 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 he or she had not leveraged the investment. 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.

RELATED TERMS
  1. Leveraged ETF

    A leveraged exchange-traded fund (ETF) is an ETF that uses financial ...
  2. Degree Of Combined Leverage - DCL

    A degree of combined leverage (DCL) is a leverage ratio that ...
  3. Leverage Ratio

    A leverage ratio is any one of several financial measurements ...
  4. Net Leverage (Insurance)

    Net leverage is the sum of an insurance company’s net premiums ...
  5. Equity Multiplier

    The ratio of a company’s total assets to its stockholders’ equity. ...
  6. Leveraged Recapitalization

    Leveraged recapitalizations replace most of a company's equity ...
Related Articles
  1. Trading

    How Much Leverage Is Right for You in Forex Trades

    It isn’t economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is at the root of trading losses.
  2. 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.
  3. Investing

    Buying ETFs on Margin Versus Leveraged ETFs

    Leveraged ETFs and investing in an ETF on margin both have their advantages and disadvantages.
  4. Financial Advisor

    Why Leveraged ETFs Are Not a Long-Term Bet

    Leveraged exchange-traded funds aren't for the average investor. They can, however, present significant upside potential for the right type of trader.
  5. 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.
  6. Investing

    Hedge Fund Failures Illuminate Leverage Pitfalls

    Learn what mistakes cause hedge funds to collapse and how to avoid similar problems.
  7. Trading

    Understanding Out Of The Money Options

    Options offer investors a way to leverage their capital for greater investment returns. Find out what out the money means for option investors.
  8. Financial Advisor

    The Debt To Equity Ratio

    The debt to equity ratio identifies companies that are highly leveraged and therefore a higher risk for investors. Find out how this ratio is calculated and how you can use it to evaluate a stock.
  9. Investing

    Deleveraging: What It Means to Corporate America

    How companies can use deleveraging—reducing debt—to be more profitable.
RELATED FAQS
  1. What are the risks of having both high operating leverage and high financial leverage?

    In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their ... Read Answer >>
  2. What is the difference between operating leverage and financial leverage?

    Discover the two equity valuation metrics, operating leverage and financial leverage, how they are similar and what differentiates ... Read Answer >>
  3. How do leverage ratios help to regulate how much banks lend or invest?

    Learn what leverage ratios mean for banks, how regulators restrict leverage, and what impact ratios have on a bank's ability ... Read Answer >>
  4. How do I calculate the degree of operating leverage?

    The degree of operating leverage is a measure used to evaluate how a company's operating income changes with respect to a ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center