What Is Financial Leverage?

Financial leverage is a business practice used by both businesses and individuals to increase their buying power when dealing in stocks, bonds and other assets. Leverage is the practice of using borrowed capital, such as debt or money from investors, to increase the potential return of an investment. With financial leverage, you can use the borrowed capital to magnify returns from a certain asset. In essence, it allows an investor to control a larger asset or position than the amount of capital used to acquire the asset or position.

The use of financial leverage has grown significantly in the past few years, due to the availability of low-cost capital from banks and investors. Investors utilize leverage to expand their portfolio size and maximize their potential return on investments. Businesses are increasingly entering into contracts with outside financing sources to increase their buying power, which can result in greater returns.

Types of Financial Leverage

There are three primary types of financial leverage: borrowed capital, equity financing and derivatives. Borrowed capital is the practice of using loans or lines of credit to purchase assets and increase return on investment. Equity financing is the practice of using equity investments to fund activities and benefit from increased returns. Lastly, derivatives are instruments that are based on the value of an underlying asset or index, such as futures, options and swaps. Each of these types of leverage carries its own risk and return.

How to Measure Financial Leverage

Financial leverage is best measured by the “debt to equity ratio,” which compares the total amount of debt to the total amount of equity available to a business. A higher debt to equity ratio indicates a higher risk of bankruptcy, since the business has taken on more debt than it can handle. Conversely, a lower debt to equity ratio reflects a lower risk of insolvency, since the business has more equity available to pay off debt in the event of default.

It’s important to remember that the debt to equity ratio is only one measure of financial leverage, so it’s important to look at other factors when considering whether or not leverage is appropriate for an investment. Other important measurements include cash flow coverage ratio, interest coverage ratio, and debt service coverage ratio.

Risks of Financial Leverage

The use of financial leverage carries with it some inherent risks. Because leverage magnifies returns, it also magnifies losses should the investment go poorly. For example, if an investor has leveraged himself with a loan for stock purchases and the stock price drops, his return on investment can become negative. If the investor is unable to pay back the loan, he can be liable for losses in excess of the original amount he borrowed.

Another risk of leveraging is increased operating costs. Leveraged investments often require higher interest payments on loans, which eats intoprofits. Furthermore, a company taking on too much financial leverage can become “over-levered,” leading to an inability to raise additional capital should the company need it in the future. This can lead to bankruptcy, as the company has taken on more debt than it can handle.

Benefits of Financial Leverage

Despite the risks, financial leverage can be a powerful tool when used appropriately. Leverage can provide businesses with the additional capital needed to finance growth and expansion, acquire new assets or take advantage of opportunities. Leverage can also yield higher returns on investments than what would be achievable without leveraging.

The greatest benefit of financial leverage is the potential to earn greater returns than what would be possible without leveraging. Investors can often justify leveraging their investments when the potential return greatly outweighs the potential risk. It’s important, however, to remember to perform due diligence and review the potential risks before leveraging a position.

Conclusion

Financial leverage is the practice of using debt or equity capital to increase the potential return on investment. This can be done through the use of borrowed capital, equity investments or derivatives. Although the use of leverage can lead to higher returns, it is important to remember that it also carries risk and should be entered into only after careful consideration of the potential risks and rewards.

References

1. Kiplinger.com - What Is Leverage? Using Debt to Amplify Returns.
2. Investopedia.com - Financial Leverage.
3. The Balance - What Is Leverage?
4. Stanford Graduate School of Business - What Is Financial Leverage?
5. The Balance - Measuring Leverage.