Leverage
Leverage refers to the use of borrowed funds with the expectation that the income or returns generated will be greater than the cost of borrowing. It is an investment strategy of using debt to finance an operation with the aim of multiplying potential returns, but at the same time, it also increases potential losses if things do not work out as planned.
There are several forms of leverage, including:
- Financial Leverage: This occurs when a company uses debt financing to fund an investment. If the firm’s return on assets (ROA) is higher than the interest rate on the debt, the shareholders will benefit because the earnings will be higher due to the larger asset base. Conversely, if the firm’s ROA is lower than the interest rate, the earnings will be lower.
- Operating Leverage: This refers to a company’s fixed costs of production. The higher the proportion of fixed costs, the higher the operating leverage. Companies with high operating leverage can see a significant increase in profits when sales volume increases, because fixed costs remain the same and a larger portion of revenues can flow through to earnings.
- Trading Leverage: In trading, leverage is provided by brokers to their clients for them to open larger positions than their capital would otherwise allow. This increases both the potential profits and potential losses.
Leverage is a double-edged sword. It can magnify profits, but it can also magnify losses. Higher leverage also implies higher risk, because it becomes more challenging for a company or individual to repay debt. Therefore, it’s essential to carefully consider the amount of leverage that is appropriate for a specific situation.
Example of Leverage
Let’s consider an example of financial leverage.
Imagine a company, Company A, wants to invest in a new project that requires $1 million. Company A only has $500,000 available in its reserves. Instead of passing on the project or raising additional equity (and diluting existing shareholders), the company decides to borrow the remaining $500,000 from a bank at an annual interest rate of 5%.
If the project succeeds and generates an annual profit of $100,000, then the return on the initial equity would be 20% ($100,000 divided by the $500,000 of equity). However, after paying the bank its interest of ,000 (0,000 times the 5% interest rate), the net profit would be $75,000. This means that, thanks to the borrowed money, the return on equity is now 15% ($75,000 divided by $500,000).
In this scenario, the use of borrowed money (leverage) allowed the company to undertake a profitable project that it could not have funded using only its own resources. However, if the project had failed to generate a profit, or if it had generated less than the $25,000 needed to pay the interest on the loan, the company could have ended up losing money or even defaulting on its loan.
This illustrates the principle of financial leverage. When successful, leverage can amplify returns. But when investments don’t pay off, leverage can amplify losses and potentially lead to financial distress. Therefore, while leverage can be a useful tool for companies and investors, it must be managed with caution.
