Leverage: Explanation, Example & Pros & Cons | Wealthsimple (2024)

The thought of debt might make you cringe. But businesses and investors use debt as a powerful tool to increase holdings and generate income. The practice of taking on debt strategically is called financial leverage.

What is Financial Leverage?

Financial leverage is also known astrading on equityor simplyleverage.It’s when you use debt (borrowed money) to purchase assets because you expect the asset to generate income or rise in value. The greater the debt, the greater the leverage. As leverage goes up, so does the risk of failure as it becomes more difficult to repay the debt.

When you bought that big TV on credit, you had to pay for it using your existing income. But when you borrow money to buy an asset, the asset can pay for itself and then some (if you bought a good asset, of course).

Borrowing money to buy more assets than you could afford on your own amplifies your returns. When the asset generates income or its value rises, you get more money back because you own more of the asset.

Leverage works the other way, too. If an asset you purchased with cash falls in value, you can only lose as much as you spent. But if you borrow to invest in an asset, it’s possible to lose moneyand still owe the debt.

Look at it like this: Your friend Tom knows about a “guaranteed” investment. (Guarantees don’t exist in investing, but this is just an example.) He promises to return your money plus 50% after one month.

But you only have $1,000! So you borrow an additional $4,000 from your bank. They want $120/month in interest. You give $5,000 to Tom and he returns $7,500 a month later. You pay the bank its $4,120 (loan plus interest) and pocket the remaining $3,380.

In this example, you leveraged your $1,000 to buy more of Tom’s opportunity than you could ordinarily afford. If you only invested your own cash, you would only earn $500. By borrowing money from a lender, you earned $2,380.

Measuring Financial Leverage

A company’s managers, shareholders, and lenders need to understand the level of risk a company carries at all times. They need to know how much a company is financially leveraged.

We can measure the financial leverage of a company using thedebt-to-equity ratio. It’s a simple formula that shows us the likelihood of a company being able to meet its debt obligations. It also tells us whether a company is capable of taking on more debt to grow.

D/E Ratio = Total Debt / Total Equity

For the purposes of this formula, total debt refers to the company’s current liabilities. This includes short-term debts that the company intends to pay within a year, as well as long term debts that will mature in more than a year.

Equity refers to the amount shareholders have invested in the company. You can find this number by multiplying the stock price by the number of outstanding shares.

If a company has $5 million in total debt and $20 million in total equity, it has a D/E ratio of 0.25. This means only a quarter of its assets are financed through debt.

If you buy stocks, part of yourinvestment strategyinclude considering a company’s D/E ratio. D/E ratios of 1.0 are not ideal. Ratios of 2.0 or higher indicates a big problem.

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How Leverage Works

Companies use leverage to acquire investments or finance new projects. The goal is to earn more from assets than the cost to acquire them through debt.

In order to safely take on financial leverage, a company or investor must be sure of two things: 1) The asset will earn enough to make the payments on the debt, and 2) The value of the asset won’t fall. If the asset doesn’t meet these conditions, it actually becomes a big liability.

A company may take on debt to buy another company, for example, as long as they believe owning the new company will make them more money than it costs to service the debt of the purchase. Or a company may take on debt to launch a new product in hopes that the product pays for the debt.

There’s a risk, of course, that the new asset won’t work out like the company intends. If that new product doesn’t make any money, the company will be stuck with a worthless asset and a bunch of debt. Deciding whether to use financial leverage is a difficult decision for companies that requires careful study and thought.

Investors use leverage as well. They “lever” their investments using different investment tools, like margin accounts, futures, andoptions. These tools boost their buying power in the market, but they also boost the risk. These investment tools arenotfor the amateur investor. You can obliterate your savings if you make a bad bet.

People or companies are consideredhighlyleveraged if servicing debts eats up a lot of income. They’reoverleveraged if servicing debts costs more than they earn.

Leverage Example

This is NOT leverage:

Acme Inc. spends $200,000 of cash to purchase a new facility.

This is an example of financial leverage:

Global Co. uses $200,000 in cash and borrows $800,000 to purchase a new facility. In this case, the company uses financial leverage to control a $1 million asset with only $200,000 of its own money. Of course, Global will have to pay interest on the loan. For the sake of our example, let’s use round numbers and say they pay $10,000/year in interest.

Why did Global Co. borrow $800,000? Because they believe the new facility will help them generate more income. They believe it will earn far more than the cost of paying back the loan (including the loan’s interest).

We can see the real power of leverage by jumping into the future. After one year, the value on our fictional facilities rise by 10%.

Since Acme Inc. bought their facility with cash, they can now sell it for $220,000 for a $20,000 profit. They made 20% on their purchase.

Global’s facility, however, is now worth $1.1 million. After you deduct the cost of the property ($1 million) and the cost of one year’s interest ($10,000), Global Co. has gained $90,000. Their original $200,000 is now $290,000, or 69% higher.

By using financial leverage, Global Co. was able to purchase a bigger asset. When that asset increased in value, Global Co. got a bigger piece than if it had only purchased an asset with its cash on hand.

Remember that financial leverage works the other way too. If the value of those facilities had fallen by 10%, Acme Inc. would have only lost 10% of their investment, or $20,000. Global Co. would have lost 50% of their investment, or $100,000.

Advantages and Disadvantages of Financial Leverage

Before you start borrowing money tobuy stocksor invest in mutual funds, it’s important to understand the pros and cons of financial leverage.

Pros of Financial Leverage

Financial leverage is a powerful tool because it allows investors and companies to earn income from assets they wouldn’t normally be able to afford. It multiplies the value of every dollar of their own money they invest.

Leverage is a great way for companies to acquire or buy out other companies or buy back equity. These events have specific growth objective. Once the objective is complete, the company should generate more income than the cost of the debt (if the managers did their homework well.)

Companies often use financial leverage to finance assets to avoid issuing stock to raise capital. This increases shareholder value because 1) the company has more assets, and 2) the value of stock isn’t diluted by the existence of more stock.

Cons of Financial Leverage

For the same reason financial leverage can boost returns on your investments, it can also amplify your losses. It can be an especially risk form of finance.

Losses can occur when the value of an investment fails to rise above the cost to borrow the money. For example, if you borrow $12,000 to buy an asset, but its value only rises by $10,000, purchasing it actually cost you $2,000.

Financial leverage can also amplify your losses when the value of the assetfalls. If the value falls far enough, it may be worth less than your loan. This means you would be stuck with debt even if you sold the asset.

Financial leverage can be especially risky in businesses with low barriers to entry or cyclical sales cycles. In both of these cases, profits can fluctuate wildly from year to year, or even in the same year. This makes it hard to pay back loans consistently and increases the odds of default.

There are some secondary effects of financial leverage as well. Highly leveraged companies often see large swings in their profit as they deal with debt. These profit swings can make the stock price volatile.

Highly leveraged companies also have reduced access to debt. It makes sense, after all, that lenders would be wary about lending to a company who already has a pile of debt. This could be disastrous if a company needs emergency cash for an emergency or a impossible-to-pass-up opportunity. If a bankdoesdecide to lend to a highly leveraged company, you can bet the terms will be stacked in the bank’s favor with lots of interest and fees to help them overcome their risk.

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