What is financial leverage and why is it important? (2023)

What is leverage?

Financial leverage comes from using debt as a source of funding to invest in expanding the company's asset base and generating returns on venture capital. Leverage is an investment strategy that uses borrowed money, specifically the use of various financial instruments orborrowed capital— Increasing the potential return on an investment.

Leverage can also refer to heightDebta company uses to finance assets.

Understand financial leverage

Leverage is the use of borrowed capital (debt capital) to carry out an investment or project. The result is a multiplication of a project's potential returns. At the same time, the leverage will also multiply the potentialadverse riskif the investment does not work. Labeling a business, property, or investment as "highly leveraged" means that 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 earned from an investment. They leverage their investments through the use of various tools includingoptions, futures and margin accounts. Companies can use leverage to fund their assets. In other words, rather than issuing stock to raise capital, companies can use debt financing to invest in operations in an attempt to increase shareholder value.

Investors who are uncomfortable using leverage directly have a variety of ways to access leverage indirectly. You can invest in companies that use debt capital in the ordinary course of business to fund or expand their operations without increasing their expenses.

leverage calculation

There are a number of financial metrics used to calculate how much debt a company is taking on to maximize profits. Below are some common leverage ratios.

Ratio of liabilities to assets

Ratio of liabilities to assets= Total Debt / Total Assets

A company can analyze its leverage by seeing what percentage of its assets were purchased with debt. A company can subtract the debt to asset ratio by 1 to find the equity to asset ratio. When the debt to asset ratio is high, a company has relied on debt financing to fund its assets.

debt ratio

debt ratio= total debt / total capital

Instead of looking at what the company owns, a company can measure leverage by looking closely at how the assets were funded. Leverage is used to compare what the company has borrowed versus what it has borrowed from private investors or shareholders.

A leverage ratio greater than one means a company has more debt than equity. However, this does not necessarily mean that a company is heavily indebted. Each company and industry tends to operate in a specific way that may justify a higher or lower ratio. For example, technology start-ups struggle to get funding and often have to turn to private investors. Therefore, a leverage ratio of 0.5 for this industry can still be considered high in comparison.

Ratio of Debt to EBITDA

Debt to EBITDA= total debt / earnings before interest, taxes, depreciation and amortization

A company can also compare its debt to the income it generates over a given period of time. The company wants to know what debt is controllable relative to operating income; Therefore, it is common to use EBITDA instead of net income. A company with a high leverage/EBITDA ratio carries high weight compared to what the company earns. The higher the debt to EBITDA ratio, the more leverage a company has.

Equity-Multiplikator

Equity-Multiplikator= total assets / total capital

Although debt is not directly accounted for in the equity multiple, it is inherently included in total assets, and total equity is directly related to total debt. The equity multiplier attempts to understand a company's ownership weight by looking at how the assets were funded. A company with a low equity multiple has a large portion of its assets funded with equity, meaning it is not highly leveraged.

Analysis by DuPontuses the "Equity Multiplier" to measure financial leverage. Equity multiplier can be calculated by dividing a company's total assets by its total equity. Once calculated, financial leverage is multiplied by total asset turnover and profit margin to arrive at a return on equity.

For example, if a public company has total assets of $500 million and equity of $250 million, the equity multiplier is 2.0 ($500 million/$250 million). With that, the company has funded half of its total assets through stocks. That's why,larger equity multiplessuggest more financial leverage.

Degree of Financial Leverage (DFL)

Degree of financial leverage = % change in earnings per share / % change in EBIT

Fundamental analysis uses theDegree of financial leverage. The degree of financial leverage is calculated by dividing the percentage change in a company's earnings per share (EPS) by the percentage change in its earningsEarnings before interest and taxes(EBIT) over a period of time. The goal of the DFL is to understand how sensitive a company's earnings per share are to changes in operating profit. A higher ratio indicates a higher level of debt, and a company with a high DFL is likely to have more volatile earnings.

Leverage Ratio of Consumers

consumer leverage= total household debt / disposable income

The above formulas are used by companies that use leverage in their trading. However, households can also use leverage. Households can also use debt capital by taking on debt and using personal income to cover interest costs.

Consumer leverage is determined by dividing a household's debt by its disposable income. Households with a higher calculated consumer debt ratio are highly indebted relative to their income and therefore heavily indebted. Finally, consumers may have difficulty obtaining credit if their consumer debt is too high. For example, lenders often set debt-to-income limits when households apply for home loans.

Benefits of Leverage

Investors and traders primarily use leverage to increase profits. Winners can become exponentially more rewarding when your initial investment is multiplied by additional seed capital. Additionally, the use of leverage gives you access to more expensive investment options that you otherwise would not have had access to with a smaller initial capital.

Leverage can be used in short-term, low-risk situations where a high level of capital is needed. For example, in the case of acquisitions or purchases, agrowing companyYou may have a short term capital need that will translate into a solid growth opportunity over the medium to long term. As opposed to using additional capital to bet on risky companies, leverage allows smart companies to seize opportunities at ideal times with the intention of quickly exiting their leveraged position.

Leverage Restrictions

When profit investing increases, so do losing investments. The use of leverage can result in much greater downside risk, sometimes resulting in losses greater than your initial capital investment. Aside from that,runnerand contract dealers charge fees, premiums and margin rates. Even if you lose on your trade, you will be aware of the additional fees.

Leverage also has the potential downside of being complex. Investors need to be aware of their financial position and the risks they are taking by taking a leveraged position. This may require additional attention to one's portfolio and the deposit of additional capital in case your trading account does not have a sufficient amount of capital according to your broker's requirements.

Leverage vs Margin

Margin is a special type of leverage that involves the use of cash or existing security positionssecurityused to increase thepurchasing poweron the financial markets.Randallows you to borrow money from a broker at a fixed rate to buy stocks, options orfuturesContracts with the expectation of receiving essentially high returns.

Therefore, you can use the margin to gain leverage and increase your buying power by the margin amount; For example, if the collateral required to buy $10,000 worth of securities is $1,000, you would have a 1:10 margin (and 10x leverage).

Leverage example

A company was created with an investment of $5 million from investors, with the company's capital being $5 million - this is the money that the company can use to operate. If the company usesfinancial debtBy borrowing $20 million, you now have $25 million to invest in running the business and more opportunities to drive shareholder value.

A car manufacturer, for example, could borrow money to build a new factory. The new factory would allow the automaker to increase the number of cars produced and increase profits. Instead of being limited to just $5 million from investors, the company can now use five times that amount to grow the business.

These types of leveraged positions appear all the time in the financial markets. For example, in March 2022, Apple issued green bonds worth $4.7 billion for the third time.Through the use of debt capital, Apple is able to expand low-carbon manufacturing, recycling opportunities and the use of zero-carbon aluminum. If the strategy yields more revenue than the cost of the bonds, Apple would have successfully leveraged its investment.