Leverage is the utilization of distinct financial tools or borrowed capital comprised to increase the possible return on an investment. Leverage is most commonly seen through real estate transactions and mortgages when individuals are purchasing a new home.
The balance of debt and equity is used to determine a firm’s assets – a firm with notable debt, rather than equity, is considered to be more highly leveraged than that of a firm with lower debt and more equity.
Leverage can be constructed through options, futures, margin, or additional financial tools. When investing, it is important to break down all options. For example: If you have $1000 to invest, that could be invested in 10 shares of stock, by taking the opportunity to invest the $1000 in five options contracts, you would control 500 shares instead of just 10.
Using debt to finance company operations is an extremely common business practice. Companies using debt to finance their operations increase their leverage because they can invest in operations without risking their equity. If a company is valued at $5 million, and they borrow $10 million, that company now has $15 million to invest in business operations and create increased value for customers and stockholders.
Just because leverage helps both the investor and the firm, does not mean it doesn’t come without risk. If the investment moves for the investor, then all are happy with the outcome, however, if the investment moves against, then the loss is far more or return is much lower, than if the investment has not been leveraged. An important point regarding leverage is that it amplifies gains as well as losses; therefore risk should be analyzed thoroughly.
Further Reading
- Behavioral consistency in corporate finance: CEO personal and corporate leverage – www.sciencedirect.com [PDF]
- Does pecking order theory explain leverage behaviour in Pakistan? – www.tandfonline.com [PDF]
- Social finance and crowdfunding for social enterprises: A public–private case study providing legitimacy and leverage – www.tandfonline.com [PDF]
- Profitability and leverage: Evidence from Nigerian firms – papers.ssrn.com [PDF]
- Debt financing and financial flexibility evidence from proactive leverage increases – academic.oup.com [PDF]
- What financing data reveal about dealer leverage – papers.ssrn.com [PDF]
- Debt maturity and the deadweight cost of leverage: Optimally financing banking firms – www.jstor.org [PDF]
- Does leverage influence banks' non-performing loans? Evidence from India – www.tandfonline.com [PDF]
