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Financial leverage is a tactic employed to potentially enhance returns. Investors leverage borrowed funds to amplify gains from an investment. In simple terms, it involves borrowing money to generate more money. Beyond just a tool for investors, businesses also use leverage to kickstart and finance growth.
We will delve into the various forms of financial leverage, when it might be advantageous to utilize the strategy, and how to calculate it.
Understanding how financial leverage operates
By using borrowed money (debt) to invest in assets like real estate or stocks, you are increasing the potential returns you could receive. If the investment performs well and earns more than the interest on the loan, you end up making more profit compared to using only your own funds.
However, there is a downside. If the investment turns sour, you stand to lose more money as you have to repay the loan on top of your initial investment.
Illustrative example of financial leverage
Consider having $10,000 to invest in the stock market. Stock B is a high-growth stock priced at $200 per share. With just your savings, you could only acquire 50 shares. Yet, you desire to purchase 100 shares.
This is where leverage comes into play. You could opt for a margin account, enabling you to borrow funds from your broker for investment purposes. Let’s say you borrow an additional $10,000 at a 5 percent interest rate. Now, with $20,000 in hand, you can purchase 100 shares of Stock B.
If Stock B’s price rises by 20 percent to $240 per share, you could sell your holdings for $24,000. After repaying the loan with interest ($10,500), you would be left with a profit of $3,500 — equating to a 35 percent return on your initial $10,000 investment. This is significantly higher than the profit you would have realized by purchasing only 50 shares of Stock B instead of 100.
However, leverage works both ways. If Stock B’s price declines, your losses are magnified. A 20 percent drop to $160 per share would mean that your holdings are valued at $16,000. You would incur losses on your investment and still be obligated to repay your margin loan with interest.
Various types of financial leverage
While not an exhaustive list, the following categorizes the types of leverage commonly available.
Asset-backed lending: Typically, this form of leverage involves using a home, car, or another asset as collateral for a loan. While prevalent, managing this type of leverage can be challenging, especially if issues with the asset or other financial factors lead to the borrower defaulting on the loan.
Cash flow loans: Businesses and investors frequently employ cash flow loans to support their operations or other endeavors when they exhaust credit or alternative financing options. Unlike asset-backed lending, a cash flow loan does not necessitate collateral. Instead, the loan is approved based on past and projected cash flow. The downside is the additional debt on your balance sheet. Moreover, if your cash flow experiences a downturn, repaying the loan can become arduous.
Investing in stocks: Investors can utilize leverage to acquire stocks through margin loans, options, and futures. Many leading online brokers offer at least one of these leverage options. While you may not replicate the performance of some of Wall Street’s elite traders, leveraging can enable you to compete beyond your financial capacity. However, if your returns fall short of expectations, you are still liable to repay the borrowed funds.
Additional instances of financial leverage
If you have financed certain purchases — such as a home — you have already accessed financial leverage, possibly without realizing it. Below are some real-world examples you may encounter:
- Obtaining a loan for an investment property. The property or properties serve as collateral, and the anticipated financial gain includes resale value for flippers or rental income for landlords.
- Buying a house. When you take out a mortgage, you commit to payments for the loan’s duration. Your home equity — which you can leverage with a loan or line of credit — grows throughout the loan term as long as you continue to make payments. This form of leverage offers numerous benefits, but defaulting could result in losing the property.
- Borrowing funds to launch a business. Most startups assume debt to secure the necessary capital for establishing their company. Sources of funding commonly include venture capital, private equity, and business loans.
- Borrowing money to invest in stocks. For instance, engaging in margin trading — borrowing against securities you possess — to purchase additional investments. Margin trading can amplify potential returns but also heightens the risk of losses. Apart from margin loans, investors can also opt for a leveraged ETF to potentially boost returns.
Calculating financial leverage in investing
No single formula exists for leverage — investors and analysts utilize various ratios to assess leverage depending on the analysis being conducted.
Here are some of the most commonly used leverage ratio calculations:
- Debt-equity ratio: This metric aids in evaluating a company’s dependence on debt. It is computed by dividing total debt by stockholder equity. A higher ratio indicates greater leverage for the company.
- Equity multiplier: The equity multiplier reveals how much a company’s equity has been leveraged. To determine this figure, divide total assets by total equity. A higher multiple signifies higher leverage for the company.
- Degree of financial leverage: This ratio gauges how a company’s earnings per share (EPS) fluctuate for each unit change in earnings before interest and tax (EBIT).
- Consumer leverage ratio: This measure examines the debt-to-disposable income ratio for the average consumer. It assists analysts in understanding individuals’ capacity to assume additional debt. The formula involves dividing total debt by disposable income.
- Debt-to-capitalization ratio: This ratio contrasts a company’s total debt with its capitalization. It indicates 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 a company’s total debt with its earnings before interest, taxes, depreciation, and amortization (EBITDA).
Benefits of financial leverage
When utilized prudently, leverage can serve as a powerful tool in your financial toolkit. It presents an opportunity to amplify potential returns on investments, enabling you to expand your reach without increasing capital. This can lead to larger-scale operations.
For example, investors and businesses can leverage borrowed funds to fuel growth initiatives like expansions and acquisitions. If managed wisely, this strategy can yield impressive returns. Nonetheless, it is crucial to handle leverage with care, as it can also magnify losses, necessitating a balanced approach.
Risks associated with leverage
Investing inherently carries risks, and with leverage, you must factor in repaying borrowed funds. In the case of investors, if you are unable to repay debt or cover losses following a decline in stock prices, you may be required to sell securities. Additionally, you may need extra funds to cover losses or withdrawals. Leverage can also be costlier than other trading strategies due to associated fees and premiums.
For loans tied to collateral, failing to meet payments could result in losing the asset. The classic example is a home loan. Defaulting on your mortgage payments could lead to foreclosure initiated by your lender. Entrepreneurs who utilize funds from friends and family to kickstart a business may encounter strained relationships if they are unable to repay the borrowed funds in case of business failure. In extreme scenarios, legal action may be pursued based on the agreement in place.
Generally, leverage should only be pursued by individuals in a financial position to absorb potential losses. As the term implies, leverage amplifies both gains and losses, with losses escalating as leverage increases. This concept is also known as the multiplier effect. For instance, a 10 percent down payment can double your funds with a 10 percent gain on the overall investment, but a 10 percent loss can eradicate your entire investment.
Final thoughts
Financial leverage can enable you to access larger investments but comes with heightened risks. Nevertheless, the prospect of accelerated growth and increased returns may be enticing. Remember, at the end of the day, you are obligated to repay any borrowed funds, regardless of the investment’s performance.