What is Leverage?
Leverage is the use of borrowed money to amplify the results of an investment.
Companies use leverage to increase the returns of investors’ money, and investors can use leverage to invest in various securities; trading with borrowed money is also known as trading on “margin.”
A “highly leveraged” company is one that has taken on significant debt to finance its operations.
Define Leverage in Simple Terms
To understand leverage, consider the difference between trying to lift a large rock with only your hands vs with a long lever.
The lever allows your strength to be amplified in order to lift much heavier objects than your strength alone would allow for.
By borrowing money, companies can amplify their results, but also their risk.
Leverage Through Debt
Increasing leverage through issuing more debt is an alternative to issuing equity.
Issuing equity gives up the rights to future profits for those shares, while issuing debt requires making periodic interest payments.
The combination of debt and equity a company uses to finance its operations is known as its “capital structure.”
Let’s look at a familiar form of leverage: a mortgage on a home.
When you put only 20% down on a home, or 1/5th, your down payment is being leveraged 5:1.
If you put 20% down on a home worth $500,000, your cash invested is $100,000.
If the home’s value increases 10% to $550,000, your gains would be magnified to 50%.
That’s because an increase of $50,000 is only 10% of the home’s value, but is a 50% increase on your investment of $100,000.
This example excludes real-life factors such as interest payments.
Additionally, the higher-leveraged a company becomes, the more at-risk they are of defaulting, causing investors to charge more for loans in the form of higher interest for the additional risk they incur.
While a company’s “leverage” is most commonly referencing its financial leverage ratio, another form of leverage is its operating leverage.
A company’s operating leverage is the relationship between a company’s fixed costs and variable costs.
Fixed costs are costs that will be incurred whether or not a unit is produced, such as rent on a building, and variable costs are costs directly tied to the production of a unit, such as the raw material to produce a product.
The more fixed costs a company has relative to variable costs, the higher its operating leverage.
Having a high operating leverage amplifies profits.
If sales increase drastically, a company with more fixed costs than variable costs will see much greater profit since it won’t incur a lot of additional expenses for each additional unit produced.
If sales sharply decline, a company with more fixed costs than variable costs will incur greater losses since it will incur its fixed costs regardless of whether or not a unit was produced and sold.