What is Leverage?

//What is Leverage?
What is Leverage? 2017-10-05T06:06:43+00:00

Definition: Leverage is the use of debt by a company to fund its operations and expansion projects in an effort to generate a return for shareholders. Companies that aggressively use debt financing are considered highly leveraged and typically risky to invest in.

What Does Leverage Mean?

What is the definition of leverage? The truth is there are several different meanings for this term. In business, a firm that uses borrowed funds to increase its return on equity incurs the risk that its return on assets is less than the cost of borrowed funds. If the firm fails to meet its short-term obligations, it may go bankrupt.

Furthermore, the EBIT may decrease, thus lowering the earnings per share. In this context, firms measure the degree of financial leverage with the DFL ratio, i.e. the ratio of the percentage change in the earnings per share to the percentage change in EBIT. Most often, they use the debt-to-equity ratio to evaluate the firm’s debt levels.

In forex trading, leverage is the ability to invest a small amount of money to achieve higher returns without binding their entire capital. Leverage is the offering of increased liquidity to investors as a tool for better risk management. By investing a portion of their capital for each position they open, investors can spread their capital over different positions, thus reducing their exposure to risk.

Let’s look at an example.

Example

Michael is a financial analyst at the Bank of America. He is asked to calculate the debt-to-equity ratio of a construction company that has recently released its financial results. Although the company released good results, the stock price keeps on declining. Michael thinks that the firm’s problem is its high debt levels.

The construction company has a long-term debt of $333.7 million, and a shareholders’ equity of $160.96 million. Michael uses the debt-to-equity ratio to measure how much capital is contributed by credits and how much capital is contributed by the firm’s shareholders. Therefore:

Debt-to-equity ratio = Debt / Equity = $333.7 / $160.96 = 2.07 = 207%.

The construction company is using debt to increase its return for shareholders. However, a debt-to-equity ratio above 2 is considered highly leveraged and quite risky. Although the company is in line with the ratio of 2.07, investors do not feel confident that the firm can meet its long-term obligations and therefore, the stock price declines.

Summary Definition

Define Leverage: Leverage is defined as the use of borrowed funds aimed at generating a return on equity for investors.