What is Leverage?
• In finance, leverage refers to any technique to multiply gains and losses. A common way to attain leverage is by borrowing money, purchasing fixed assets or partaking in derivative contracts. The following examples will represent common situations where leverage is used:
o A business entity may leverage its revenue by purchasing fixed assets. These purchases will increase the ratio of fixed to variable costs, meaning that a fluctuation in revenue will result in a larger change in operating income.
o Hedge funds will typically leverage their assets by purchasing and selling derivative contracts.
o A public company may leverage its equity by borrowing money. The more money the corporation borrows, the less equity capital it will need. Any profits or losses, in this scenario, are shared among a smaller base and are proportionately larger as well.
How do you Measure Leverage?
• Leverage, as a term, carries many different definitions across a number of fields. For instance, accounting leverage refers to total assets divided by total assets minus total liabilities. Economic leverage, in contrast, is the volatility of an equity divided by the volatility of an unlevered investment in the same group of assets.
• In finance, leverage is often referred to as operating income divided by net income. Within this definition, analysts will utilize operating leverage to estimate the percentage change in operating income for a one percent change in revenue. The product of these two forms of leverage is referred to as total leverage, which is used to estimate the percentage change in net income for a one percent change in revenue.
Risks Associated with Leverage:
• The popular prejudice attached to leverage is that people who borrow a significant amount of money often end up defaulting or falling into a financial mess. The primary issue with that observation is that these investors are not leveraging anything; they are simply borrowing money for consumption.
• In finance, the traditional practice is to borrow money for the purpose of buying assets that yield a higher return than the interest on the debt. That being said, there are risks to leverage, the most obvious being a case where an investor experiences multiple losses.
• For example, a company that borrows too much money may face bankruptcy if the entity’s investments all lost money or if they borrowed such funds during a business downturn.
• If an investor purchases a stock on 50% margin, he or she will lost 40% of the principal if the stock declines 20%–this is the risk associated with leveraging investments.