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.
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Deeper Understanding of Leverage
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.
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Leverage vs Margin
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Although interconnected—since both involve borrowing—leverage and margin are not the same. Leverage refers to taking on debt, while margin is debt or borrowed money a firm uses to invest in other financial instruments.
A margin account allows you to borrow money from a broker for a fixed interest rate to purchase securities, options, or futures contracts in the anticipation of receiving substantially high returns. You can use margin to create leverage.
Disadvantages of Leverage
Leverage is a multi-faceted, complex tool. The theory sounds great, and in reality, the use of leverage can be profitable, but the reverse is also true. Leverage magnifies both gains and losses. If an investor uses leverage to make an investment and the investment moves against the investor, their loss is much greater than it would've been if they have not leveraged the investment.
For this reason, leverage should often be avoided by first-time investors until they get more experience under their belts. In the business world, a company can use leverage to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroy shareholder value.
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Operating and Financial Leverage
Through balance sheet analysis, investors can study the debt and equity on the books of various firms and can invest in companies that put leverage to work on behalf of their businesses. Statistics such as return on equity (ROE), debt to equity (D/E), and return on capital employed (ROCE) help investors determine how companies deploy capital and how much of that capital companies have borrowed.
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To properly evaluate these statistics, it is important to keep in mind that leverage comes in several varieties, including operating, financial, and combined leverage.
A degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. The degree of financial leverage (DFL) measures the percentage change in EPS for a unit change in operating income, also known as earnings before interest and taxes (EBIT).
This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.
DFL= % Change is EPS
%Change is EBIT
The degree of operating leverage (DOL) is a multiple that measures how much the operating income of a company will change in response to a change in sales. Companies with a large proportion of fixed costs (or costs that don't change with production) to variable costs (costs that change with production volume) have higher levels of operating leverage.
The DOL ratio assists analysts in determining the impact of any change in sales on company earnings or profit.
DOL= % Change is EBIT
% Change is Sales