What is Leverage?
Leverage is a financial method of using debt to finance an undertaking that will provide returns that exceed the cost of that debt.
Leverage can also refer to debt that a company currently has; to say that a firm is “highly leveraged” means that it has considerably more debt than equity.
Define Leverage in Simple Terms
There are two primary ways a company raises capital for operations; either through selling equity or by raising debt.
Raising equity is usually a safer investment, but has the downside of diluting shareholder percentage ownership of the company.
For example, say a watch manufacturer has one factory and $500,000 in equity.
In order to open a second factory, the manufacturer needs $1 million.
They could opt to raise another $500,000 in equity, which would increase the number of shares outstanding.
Alternatively, they employ leverage to take out a loan of $500,000 in order to open a second factory.
Assuming the factory doubles their profit, then the debt they take on may amplify the returns and increase the value of each share.