Financial leverage means using borrowed money to fund business activities. Businesses often use leverage to invest in expansions, acquisitions, or other ways to grow. Leverage is also a strategy where investors use borrowed funds or financial tools to potentially increase their investment returns.
The percentage of the money you are allowed to “borrow” from your broker to open a position. Think of it as a “loan” from your broker. It helps traders to trade higher volumes with a smaller amount of money. The more you leverage your money, the higher the potential for profit, and the risk of loss from trades.
Understanding Financial Leverage
Leverage means using borrowed money to invest or start a project. It’s commonly used to strengthen the financial base of a business. Both investors and companies use leverage:
- Investors: They use leverage to increase potential returns on investments. They do this by using different financial tools like options, futures, or margin accounts.
- Companies: They use leverage to finance their assets instead of issuing more stock. This means they borrow money to invest in their business and help it grow.
Investors who don’t want to directly use leverage have other options. They can invest in companies that already use leverage in their everyday operations, which helps them grow without spending more money.
The main goal of financial leverage is to increase potential returns from a project. However, it also increases the risk if the investment doesn’t work out. When something is called “highly leveraged,” it means it has more debt than equity, whether it’s a company, property, or investment.
How to Calculate Financial Leverage
Many leverage financial ratios help calculate how much debt a company is using to try to increase profits. Here are some common ones:
- Debt-to-Equity Ratio: This compares a company’s total debt to its shareholders’ equity. It shows how much debt the company has for every dollar of equity.
- Debt Ratio: This ratio measures the proportion of a company’s assets financed by debt. It compares total debt to total assets.
- Interest Coverage Ratio: This indicates a company’s ability to pay interest on outstanding debt. It compares earnings before interest and taxes (EBIT) to interest expenses.
- Debt-to-Capital Ratio: This compares a company’s total debt to its total capital (debt plus equity). It shows the proportion of capital that comes from debt.
These ratios help investors and analysts understand how much debt a company is using and its ability to manage that debt while maximizing profits.
Example
Let’s say a company starts with a $5 million investment from investors, which becomes its equity for operations. If the company decides to borrow $20 million through debt financing, it then has a total of $25 million to invest in its operations. This can create more opportunities to grow and increase value for shareholders. However, it also means the company has a high debt-to-equity ratio, which might be normal or concerning depending on its industry standards.
Companies often use this kind of leverage. For instance, Apple issued $4.7 billion of Green Bonds in March 2022 for the third time. By taking on debt, Apple aimed to expand its low-carbon manufacturing and recycling initiatives, including using carbon-free aluminum. Such leverage strategies can succeed when the increased revenue outweighs the debt incurred from issuing bonds.
FAQs
Financial leverage means borrowing money to invest in things. The idea is to make more money from what you invest in than what you pay in interest for borrowing the money. It’s a way to make more profit without putting in more of your own money.
Here’s an example of financial leverage: Let’s say you want to buy a rental property. You put down 20% of the property’s cost, and you borrow the remaining 80% from a lender. Then, you try to rent out the property. The money you make from rent helps you pay back the loan each month. If you can cover your costs with the rent money, you’ve used leverage well. This way, you gain ownership of the house and the chance to make extra money from rent.
Financial leverage can be measured using various methods. One common way is by using leverage ratios. These ratios help us understand how much a company relies on borrowed money compared to its assets. The two main leverage ratios are:
Debt-to-equity ratio: This compares the total debt a company owes to its total equity (ownership) in the company.
Debt-to-assets ratio: This compares the total debt a company owes to its total assets.
These ratios give insight into how much debt a company has relative to its ownership and assets.
Typically, if a company’s debt-to-equity ratio is higher than one, it means the company has chosen to rely more on borrowing money than on funds from shareholders. This isn’t necessarily a bad thing, but it does mean the company could face higher risk because of fixed debt obligations. To understand if the ratio is good or bad, you need to compare the company to others in the same industry or look at its past financial performance. This helps determine whether the company’s leverage ratio is healthy.
Financial leverage is crucial because it opens up possibilities for investors and businesses. However, it also brings high risks, especially for investors because it can make losses bigger during tough times. For businesses, leverage means taking on more debt, which can be difficult to repay if there are economic slowdowns in the following years.
Conclusion
There are various ways individuals and companies can increase their equity base, and financial leverage is one of them. Financial leverage for businesses means borrowing money to expand and grow. It also enables investors to enter into investments with smaller initial payments.
However, since using leverage involves risks, it’s crucial to weigh the pros and cons and decide if it aligns with your financial situation and objectives.