In its simplest terms, leverage is borrowing. Whether that borrowed money is used by a company for expansion, or a trader to super-charge the potential return of an investment, leverage can be a powerful tool.
Just as a lever is used to increase the force needed to lift a heavy object – with only a small movement on one side producing a much larger move on the other – leverage can make it easier to magnify returns. However, its use can increase risks on the downside too.
If you were to buy a house for $1 million, using $100,000 of your own money and $900,000 borrowed from the bank, your leverage ratio would be 10:1. In other words, you put down $1 of equity for every $10 in asset value. If prices go up 10%, your investment is worth $1.1 million, and you’re left with $200,000 after paying back the $900,000 loan. But if you chose to sell after prices fall 10%, you’re initial investment has evaporated. If the value of the house falls 20%, not only have you lost your initial $100,000, but you owe another $100,000 on top of that.
Similarly, using leverage to buy a specific stock can lead to bigger gains or greater losses than if no money was borrowed. That’s why companies with too much leverage can become a credit risk and face downgrades, default or bankruptcy.
Since leverage is as a tool that magnifies investor gains or losses, any investment that may be plain on the surface, can be transformed into something far more exciting by using leverage or borrowed money.
Brokers offer investors margin accounts that typically charge fixed interest rates as a way to utilize leverage. Options and futures are other ways to lever an investment portfolio.
Leverage ratios are closely watched by investors and credit rating agencies to determine a company’s health. One of the most common leverage measures is the debt-to-equity ratio, calculated by dividing total liabilities by total shareholder equity. Too much leverage is never a good thing, but what signifies a dangerous level, depends on what industry a company operates in, what the macro environment looks like, and what initiatives are being pursued.
On the flip side, too little leverage may demonstrate that a company is playing it too safe, and isn’t willing to take advantage of opportunities to potentially increase its earnings. The interest coverage ratio, which measures a company’s ability to pay its borrowing costs, is a good gauge of this.
The equity multiplier is another financial leverage ratio, and compares shareholder equity with total assets.
It is also important to understand the differences between operating leverage and financial leverage. The former measures how much of a company’s total costs are fixed, and determines at which point it will break even in terms of profitability. The latter, meanwhile, is the use of borrowed capital to acquire assets or conduct business. Highly leveraged companies typically have more debt than equity.
Another term to be familiar with is gearing, another measure of financial leverage. It measures how much of what a company is doing is funded by shareholder equity, as opposed to borrowing.
Too much leverage is never a good thing, but remember that debt can multiple both your risk and reward.