Financial leverage: What it is and why it matters

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Financial leverage is a strategy used to potentially increase returns. Investors use borrowed funds intending to expand gains from an investment. Simply put, it’s borrowing money to make more money. Not just a tool for investors, leverage is used by businesses to launch as well as fund growth.

We’ll break down the different types of financial leverage, when you might use the strategy and how to calculate it.

How financial leverage works

By borrowing money (debt) to invest in something like a property or a stock, you’re magnifying the potential returns you could see. If the investment performs well and earns more than the interest you pay on the loan, you end up profiting more than if you had only used your own cash.

However, there’s a flip side. If the investment goes south, you lose more money because you have to repay the loan on top of your own investment.

Example of financial leverage

Imagine you have $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’d only be able to purchase 50 shares. But you want to purchase 100 shares.

Here’s where leverage comes in. You could use a margin account, which allows you to borrow money from your broker to invest. Let’s say you borrow an additional $10,000 at a 5 percent interest rate. Now you have $20,000 and can buy 100 shares of Stock B.

If Stock B increases in price by 20 percent to $240 per share, you could sell your holdings for $24,000. After repaying the loan with interest ($10,500), you’d be left with a profit of $3,500 — a 35 percent return on your initial $10,000 investment. That’s significantly more than the profit you would have made by only purchasing 50 shares of Stock B instead of 100.

However, leverage is a double-edged sword. If Stock B’s price falls instead, your losses are amplified. A 20 percent drop to $160 per share would mean your holdings are only worth $16,000. You’d lose money on your investment and still need to pay back your margin loan with interest.

Types of financial leverage

While not exhaustive, the following list loosely categorizes the types of leverage available.

Asset-backed lending: Typically, this use of leverage involves a home, car or another purchasable item that serves as collateral for a loan. While this type of leverage is common, it can also be difficult to manage especially if the asset or some other financial issue causes the borrower to default on the loan.

Cash flow loans: Businesses and investors often use cash flow loans to fund their operations or other activities when they run out of credit or other financing options. Unlike asset-backed lending, a cash flow loan doesn’t require collateral. Instead, the loan is granted based on past and forecasted cash flow. The downside is added debt to your balance sheet. And, if your cash flow nosedives, it’ll be difficult to repay the loan.

Investing in stocks: Investors can also use leverage to purchase stocks through margin loans, options and futures. Many of the best online brokers offer at least one of those leverage options. While you might not be able to replicate the performance of some of Wall Street’s elite traders, you can try to punch above your weight class by using leverage. However, if your returns aren’t as expected, you’ll still have to repay the borrowed funds.

Other examples of financial leverage

If you’ve financed certain purchases — like a home — you’ve already accessed financial leverage, perhaps without even knowing it. Here are some additional real-world examples you might come across:

• Taking out a loan for an investment property. The collateral is the home or homes, and the projected financial gain is the resale price if you’re a flipper or the rental income if you’re a landlord.
• Purchasing a house. When you take on a mortgage, you’ll have payments for the life of the loan. Your home equity — which you can tap into with a loan or line of credit — increases during the life of the loan, as long as you keep paying. This type of leverage has many benefits, but if you default, you lose the property.
• Borrowing money to launch a business. Most startups take on debt to gain the necessary capital to get their company up and running. Venture capital, private equity and business loans are all common sources of funding.
• Borrowing money to invest in stocks. For example, when you buy on margin — borrowing against securities you hold — to buy more investments. Margin trading can amplify your potential returns, but it also increases the potential for losses. Beyond margin loans, investors can also buy a leveraged ETF to potentially increase returns.

How to calculate financial leverage in investing

There’s no single formula for leverage — investors and analysts use various ratios to measure leverage. It all depends on what is being analyzed.

Here are some of the most common leverage ratio calculations:

1. Debt-equity ratio: This number helps measure a company’s reliance on debt. It’s calculated by dividing total debt by stockholder equity. The larger the ratio, the more leveraged the company.
2. Equity multiplier: The equity multiplier tells you how much a company’s equity has been leveraged. Divide total assets by total equity to find this figure. The larger the multiple, the more highly leveraged the company.
3. Degree of financial leverage: This ratio measures how much a company’s earnings per share (EPS) increases or decreases for each unit change in earnings before interest and tax (EBIT).
4. Consumer leverage ratio: This measure looks at the debt-to-disposable income ratio for the average consumer. This ratio can help analysts understand the ability of individuals to take on more debt. The formula is total debt divided by disposable income.
5. Debt-to-capitalization ratio: This ratio compares a company’s total debt to its capitalization. It’s a measure of the risk a company takes on to increase profits. The formula is debt divided by debt plus shareholder equity.
6. Debt-to-EBITDA leverage ratio: This ratio compares a company’s total debt to its earnings before interest, taxes, depreciation and amortization (EBITDA).

Advantages of financial leverage

Leverage, when employed judiciously, can serve as a potent tool in your financial arsenal. It may provide an opportunity to magnify your possible returns on investments, allowing you to achieve a larger footprint without an increase in capital. This could lead to larger scale operations.

For instance, investors and businesses can utilize borrowed funds to fuel growth strategies such as expansions and acquisitions. If executed wisely, this can yield impressive returns. However, it’s important to manage leverage with care, as it also has the potential to amplify losses, necessitating a balanced approach.

Risks of leverage

Investing comes with risks, and with leverage, you have to account for paying back borrowed funds. For investors, if you’re unable to repay debt or cover losses in the event of a decline in stock prices, you may have to sell securities. You may also need additional funds to cover losses or withdrawals. Leverage can also be more costly than other trading strategies due to the associated fees and premiums.

For loans tied to collateral, you could lose the asset if you can’t cover the payments. The obvious example is a home loan. If you can’t make your mortgage payments, you’ll default and your lender will start the foreclosure process. And for entrepreneurs, if you use money from friends and family to fund a business and it fails, your relationships may sour if you can’t repay the borrowed cash. Even worse, you could be subject to a lawsuit, depending on what sort of agreement you have in place.

For the most part, leverage should only be pursued by those in a financial position to absorb potential losses. As the name implies, leverage magnifies both gains and losses, so the potential for losses increases as leverage increases. Another term for this is the multiplier effect. Take, for instance, a down payment of 10 percent. While a 10 percent gain on the overall investment can double your funds, a 10 percent loss can wipe out your entire investment.

Bottom line

Financial leverage can help you tap into bigger investments, but it comes with increased risk. Still, the chance at accelerated growth and increased returns might be worth it to you. Just remember, at the end of the day, you’ll still have to repay what you borrow, regardless of how well the investment performs.