Financial 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.
Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.
Investors use leverage to multiply their buying power in the market.
Companies use leverage to finance their assets—instead of issuing stock to raise capital, companies can use debt to invest in business operations in an attempt to increase shareholder value.
There is a range of financial leverage ratios to gauge how risky a company's position is, with the most common being debt-to-assets and debt-to-equity.
Misuse of leverage may have serious consequences, as there are some that believe it played a factor in the 2008 Global Financial Crisis.
Leverage is the use of debt (borrowed capital) in order to undertake an investment or project. The result is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out. When one refers to a company, property, or investment as "highly leveraged," it means that item has more debt than equity.
The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments, including options, futures, and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
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.
Leverage might have played a factor in the 2008 Global Financial Crisis. Some believe that instead of settling for modest returns, investment companies and borrowers got greedy, opened leverage positions, and caused major market repercussions when their leveraged investments missed the mark.
Instead of looking at what the company owns, a company can measure leverage by looking strictly at how assets have been financed. The debt-to-equity ratio is used to compare what the company has borrowed compared to what it has raised by private investors or shareholders.
A debt-to-equity ratio greater than one means a company has more debt than equity. However, this doesn't necessarily mean a company is highly levered. Each company and industry will typically operate in a specific way that may warrant a higher or lower ratio. For example, start-up technology companies may struggle to secure financing and must often turn to private investors. Therefore, a debt-to-equity ratio of .5 may still be considered high for this industry compared.
A company can also compare its debt to how much income it makes in a given period. The company will want to know that debt in relation to operating income that is controllable; therefore, it is common to use EBITDA instead of net income. A company that has a high debt-to-EBITDA is carrying a high degree of weight compared to what the company makes. The higher the debt-to-EBITDA, the more leverage a company is carrying.
Although debt is not directly considered in the equity multiplier, it is inherently included as total assets and total equity each has direct relationships with total debt. The equity multiplier attempts to understand the ownership weight of a company by analyzing how assets have been financed. A company with a low equity multiplier has financed a large portion of its assets with equity, meaning they are not highly levered.
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.