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Financial leverage is a strategy that can potentially enhance returns. Investors leverage borrowed funds to amplify gains from an investment. In simple terms, it involves borrowing money to generate more profit. Businesses also use leverage to start and finance growth initiatives.
We will explore the various types of financial leverage, scenarios where this strategy may be applicable, and how to calculate it.
Understanding financial leverage
By using borrowed money (debt) to invest in assets such as real estate or stocks, investors can increase the potential returns they may receive. If the investment performs well and earns more than the interest paid on the loan, the investor stands to make a higher profit compared to using only their own capital.
However, there is a downside. If the investment underperforms, the investor may incur greater losses as they have to repay the loan in addition to their initial investment.
Illustration of financial leverage
Suppose you have $10,000 to invest in the stock market. Stock B is a high-growth stock priced at $200 per share. With your savings alone, you can only purchase 50 shares. But you aim to acquire 100 shares.
This is where leverage comes into play. By utilizing a margin account that allows you to borrow funds from your broker for investment purposes, you could borrow an additional $10,000 at a 5 percent interest rate. With a total of $20,000, you can now purchase 100 shares of Stock B.
If the price of Stock B rises by 20 percent to $240 per share, you could sell your shares for $24,000. After repaying the loan with interest ($10,500), you would be left with a profit of $3,500 — a 35 percent return on your initial $10,000 investment. This is significantly higher than the profit you would have made by purchasing only 50 shares of Stock B instead of 100.
However, leverage has its risks. If the price of Stock B declines, your losses will be magnified. For instance, a 20 percent drop to $160 per share would result in your holdings being worth $16,000. You would incur losses on your investment and still be required to repay the margin loan with interest.
Types of financial leverage
While not exhaustive, the following list provides a loose categorization of the types of leverage that are available.
Asset-backed lending: Typically involving assets such as homes or cars that serve as collateral for a loan. While common, this type of leverage can be challenging to manage, especially if issues with the asset or other financial factors lead to loan default.
Cash flow loans: Businesses and investors often utilize cash flow loans to support their operations or other activities when traditional credit or financing options are exhausted. Unlike asset-backed lending, cash flow loans do not require collateral; instead, they are based on historical and projected cash flow. However, taking on additional debt can impact the balance sheet, and repayment may become difficult if cash flow declines.
Stock market investments: Investors can leverage funds to purchase stocks through margin loans, options, and futures. Many online brokers offer these leverage options, allowing investors to potentially enhance returns. Nevertheless, if the results do not meet expectations, the borrowed funds still need to be repaid.
Additional examples of financial leverage
Many people have accessed financial leverage without realizing it, such as through financing certain purchases like homes. Here are a few more real-world examples:
- Obtaining a loan for an investment property: The property serves as collateral, and the expected financial gain is from either the resale value (for flippers) or rental income (for landlords).
- Buying a house: When obtaining a mortgage, payments are made throughout the loan term. Home equity, which can be accessed through a loan or line of credit, increases over time as long as payments are maintained. While this form of leverage offers numerous benefits, defaulting on payments could result in losing the property.
- Securing funds to launch a business: Many startups acquire debt to acquire the necessary capital for their operations. Common sources of funding include venture capital, private equity, and business loans.
- Borrowing to invest in stocks: For instance, using margin trading — borrowing against securities to purchase additional investments. While this strategy can amplify potential returns, it also increases the risk of losses. Apart from margin loans, investors can also consider investing in leveraged ETFs to potentially boost returns.
Calculating financial leverage in investing
There is no single formula for calculating leverage, as investors and analysts utilize various ratios to assess leverage based on the specific context. Here are some commonly used leverage ratio calculations:
- Debt-equity ratio: This ratio gauges a company’s dependence on debt by dividing total debt by stockholder equity. A higher ratio indicates greater leverage.
- Equity multiplier: This ratio reveals how much a company’s equity has been leveraged by dividing total assets by total equity. A higher multiplier signifies higher leverage.
- Degree of financial leverage: This ratio measures the impact of changes in earnings before interest and tax (EBIT) on a company’s earnings per share (EPS).
- Consumer leverage ratio: This ratio examines the debt-to-disposable income ratio for the average consumer, providing insights into individuals’ capacity to take on additional debt. The formula is total debt divided by disposable income.
- Debt-to-capitalization ratio: This ratio compares total debt to capitalization, indicating the level of risk a company assumes to boost profits. The formula is debt divided by debt plus shareholder equity.
- Debt-to-EBITDA leverage ratio: This ratio compares total debt to earnings before interest, taxes, depreciation, and amortization (EBITDA).
Benefits of financial leverage
When used wisely, leverage can be a powerful tool in your financial strategy. It offers the potential to amplify returns on investments, enabling you to expand your portfolio without requiring additional capital. This can lead to larger-scale operations.
For instance, investors and businesses can leverage borrowed funds to drive growth initiatives such as expansions and acquisitions. When implemented prudently, this approach can yield significant returns. However, it is crucial to manage leverage carefully, as it can also magnify losses, necessitating a balanced approach.
Risks associated with leverage
Investing inherently involves risks, and leveraging introduces the obligation to repay borrowed funds. If investors are unable to settle debts or cover losses resulting from a decline in stock prices, they may need to sell securities. Additional funds may be required to cover losses or withdrawals. Leverage can also be costlier compared to other trading strategies due to associated fees and premiums.
For loans secured by collateral, defaulting on payments could lead to losing the asset. The classic example is a home loan, where failure to make mortgage payments can trigger foreclosure. Entrepreneurs who use funds from friends and family to finance a business may encounter strained relationships if they are unable to repay the borrowed funds. In the worst-case scenario, legal action may be pursued depending on the terms of the agreement.
Leverage should ideally be pursued by individuals in a stable financial position to absorb potential losses. As the name suggests, leverage amplifies both gains and losses, with the risk of losses increasing as leverage grows. This is known as the multiplier effect. For instance, with a 10 percent down payment, a 10 percent increase in the overall investment can double funds, while a 10 percent loss could wipe out the entire investment.
Conclusion
Financial leverage can offer the opportunity to access larger investments, but it comes with heightened risks. Despite the potential for accelerated growth and increased returns, investors must bear in mind that borrowed funds must be repaid regardless of the investment’s performance.