What Is Financial Leverage?

Introduction

Financial Leverage is a powerful tool used in business to increase profitability. It can be described as the ability to use borrowed money as a means of investing in order to gain a larger return on investment than what would have been possible without borrowing. Financial Leverage provides a business with the resource to expand their operations, invest in new projects, and make investments in more liquid assets.

The purpose of Financial Leverage is to increase the rate of return of a given investment by increasing the amount of money that an entity has for investment. By utilizing Financial Leverage, an entity can increase their returns on investments with a lower risk rate and thereby increase profit. For example, if an entity needs to make an investment of $1,000, but has only $300, they may be able to borrow the remaining $700 in order to invest in a more lucrative venture.

Examples of Financial Leverage

Financial leverage is an investment strategy designed to increase returns on capital. It can allow investors to magnify gains by using methods such as borrowing to finance projects or using financial instruments, such as derivatives and swaps, to increase potential returns while minimizing risk. Financial leverage is a powerful tool, but it can be risky if not used properly.

Borrowing to Finance Projects

Borrowing to finance projects is a common way to leverage a return on capital. Investors may use leverage to purchase more shares of stock than what their capital can traditionally buy. For example, if an investor has $10,000 to invest and want to buy $20,000 worth of shares, they may borrow the additional $10,000 to do this. The investor pays interest on the loan and aims to make a profit from the return of their investment.

Using Financial Instruments to Increase Returns

Financial instruments, such as derivatives and swaps, can be used to increase potential returns. Derivatives, such as futures and options, allow investors to profit from changes in the price of an underlying asset without owning the asset. Swaps are contracts in which two parties exchange financial obligations or cash flows over a specified period. Using these instruments can be a way to increase returns while potentially minimizing risk.

• Futures
• Options
• Swaps

Benefits of Financial Leverage

Financial leverage is the use of borrowed funds to finance an investment. This can be in the form of debt, such as a loan or bond, or equity, such as angel investors or venture capital. It can provide a range of benefits to investors, from increased returns to access to funds for major investments.

Increases Rate of Return on Investments

Financial leverage can increase the rate of return on investments. By borrowing funds for the investment, larger investments can be made and the return can be maximised. This can be beneficial to investors, as it gives them the opportunity to make larger returns than they otherwise would with the same amount of money.

Ability to Access Funds for Major Investments

Financial leverage is also useful for investors who want to access funds for major investments. Borrowing funds can provide access to a larger amount of money, which can be used to fund larger investments. This allows investors to take advantage of opportunities that may not be available to them otherwise. Additionally, interest payments are typically tax-deductible, enabling investors to increase their profitability.

Potential for Higher Returns on Investments

Finally, financial leverage can provide investors with the potential for higher returns. By investing more capital, investors can benefit from the higher returns that are associated with larger investments. Additionally, financial leverage can also reduce the risks associated with investing, allowing investors to benefit from potential appreciation in their investments.

• Increases rate of return on investments
• Ability to access funds for major investments
• Potential for higher returns on investments

Drawbacks of Financial Leverage

Financial leverage can provide access to capital that may otherwise be out of reach, but strategic financing carries with it a number of potential drawbacks. Included among these potential drawbacks:

Potential for Realization Losses

Leveraging can increase the potential for losses in a portfolio, as the amount of borrowed money amplified the effects of losses. This is especially true when carried out in a reactionary manner and can “skew” results over reasonable timeframes. Furthermore, strategically timed investments must be used when leveraging, or else the potential for losses increases.

Excess Exposure to Financial Markets

Financial leveraging can result in a portfolio that has too much exposure to markets, since the loan funds are used to purchase additional investments. This makes the portfolio overly volatile, even when diversified to a reasonable extent. This can also be seen as chasing gains that might not be able to be realized as intended.

Incurring Higher Debt Obligations

This is the most obvious downside, as financial leveraging involves entering into a loan agreement to acquire funds, with the understanding that the debt must be repaid. If the investments do not produce the expected returns, then the need to repay the loan can become a struggle.

Impact of Financial Leverage

Financial leverage is a business strategy that increases profitability by taking on additional debt to increase the value of assets, fund new projects, or bolster cash flow. While leverage can increase returns, it also amplifies risk and can dramatically affect a business's ability to stay afloat. Here, we'll explore the impact of financial leverage on a business.

Increases Debt Load

The most evident impact of financial leverage is an increase in the total debt load of a business. This is because leverage is a form of borrowing which adds to the company's existing debt obligations. High levels of debt can decrease a company's borrowing power and make it more difficult to access additional financing options.

Increases Risk of Default

The primary risk of leveraging is the increased risk of default. Defaulting on debt payments can significantly damage a company's credit rating, make it difficult to access financial resources, and even result in bankruptcy in severe cases.

Impact on Credit Ratings

The increased risk of default also has implications for a business's credit ratings. Poor credit ratings can lead to higher borrowing costs, decreased access to financing resources, and a lack of confidence from potential investors. An inability to pay debt in a timely and consistent manner could lead to a significant decrease in credit ratings, making it difficult for companies to operate.

Financial leverage increases a company's potential returns, but also takes on additional risk. Increasing debt loads, inability to pay debt obligations, and damage to credit ratings are some of the impacts of financial leverage that business owners need to consider when making strategic decisions.

Calculating Financial Leverage

Financial leverage is an important accounting concept to understand when venturing into investments. It represents the amount of debt used to fund operations and investments. By understanding how much money is borrowed, it establishes how much money is available for the return on investments.

Financial leverage can be calculated using the Debt to Equity Ratio, which is a simple equation: Total Liabilities divided by Total Equity.

Calculate the Debt to Equity Ratio

The Debt to Equity ratio should include all liabilities, such as long-term debt, short-term debt, mortgage, accounts payable, and payroll taxes. Equity is generally made up of stocks, common and preferred shares, and retained earnings.

Assess Gains and Losses on Investments

The Debt to Equity ratio provides an opportunity to assess gains and losses on investments that are funded with debt. Leverage affects returns the same way a lever affects force. The greater the leverage, the greater the returns, either positive or negative. For example, assume $100,000 of equity generates $10,000 of income from operations. If the same equity is leveraged with a $400,000 loan to purchase an investment, the return on the investment would be 40% ($40,000 income return).

Conclusion

In this blog post, we explored financial leverage and the basics of how it works. Financial leverage involves borrowing money to purchase investments that offer greater returns than the amount of money borrowed. It can be a powerful tool for amplifying returns when used strategically, but it also carries a certain level of risk. If a borrower is not able to meet their debt obligations and repay the borrowed funds, they could face financial losses.

When leveraged properly, businesses and individuals can use financial leverage to increase their return on investments. Because borrowed money carries the promise of a larger return, the risk must be carefully managed. Knowing the investment goals and associated risks of leverage will help ensure that the strategy is used in a way that offers the most benefit, without taking on too much risk.

Summary of Main Points

• Financial leverage involves borrowing money in order to purchase investments that offer greater returns than the amount borrowed.
• Though it is a powerful tool, financial leverage can also bring risk. If a borrower is unable to meet their debt obligations, they may suffer financial losses.
• Effective use of financial leverage involves assessing risks and knowing the desired investment goals.

Final thoughts on Financial Leverage

Financial leverage is an important tool for recognizing greater returns on investments. It should be used responsibly and with a clear understanding of the risks involved. By weighing the potential gains versus the potential losses of leverage, individuals and businesses will be able to employ leverage with confidence.