Understanding Leverage in Finance

This article will explain the concept of leverage in finance in detail. You will learn about its types, use, advantages and disadvantages.

 

 Table of Contents

1. What is leverage?
2. Types of leverage
3. About leverage ratios
4. How does it work for businesses and individuals?
5. Why do businesses use leverage?
6. Advantages and Disadvantages of Leverage

What is Leverage?

Debt leverage or leverage in finance is an investment strategy of using borrowed funds to purchase assets, raise funds and maximize returns on investments. It is a method that multiplies both gains and losses. 

If you have the risk capacity, you can use leverage to magnify your gains. In most cases, investors and companies use it to significantly increase their profits. Many companies use it for financing their assets. Those who do not want to directly use debt leverage can invest in companies that use leverage for their business operations. 

The investor using leverage will have to repay the lender an added amount as interest. Remember that leverage will only work in your favour if the returns on investments are more than the interest on the loan amount.

Gains through Leverage:

 Returns on Investment > Interest on Loan Amount

Loss through Leverage:

 Returns on Investment < Interest on Loan Amount

Types of Leverages

There are three types of leverage in finance: Operating, financial, and working capital leverage. Both are not independent of each other. Let us learn about them in detail:

1. Operating Leverage: It is the measure of fixed costs of a company in comparison with the total cost of the company. Any firm has three types of operating costs. These include fixed cost, semi-fixed/semi-variable, and variable cost. 

Fixed cost does not change with sales and is still paid. Variable cost varies with sales revenue. If there is no sale, then there will be no variable cost. Semi-variable/semi-fixed varies over a range of sales and then gets fixed. 

Operating leverage is also referred to as ‘Degree of Operating Leverage (DOL).’ DOL is a financial ratio that determines how efficiently a company uses the fixed cost to generate operating income. If the DOL is more, the profits are also high.

 

2. Financial Leverage: It is the use of debt to purchase more assets. Financial leverage is calculated as the ratio of the total debt to total assets; if this leverage ratio increases, then the amount of financial leverage also increases. 

3. Working capital leverage: It defines the impact of work capital on a company’s profitability. To increase the return on capital employed (ROCE), it is important to increase the productivity of investments in current assets. 

What is Leverage Ratio?

A leverage ratio is a financial measurement to assess if a company is capable of meeting its financial obligations. It tells how much capital is coming from debt. Once you know this amount, you can easily evaluate if the company can pay the due debts. There are different financial ratios. 

Types of Leverage Ratios

It is a type of financial ratio that indicates the debt incurred by a business entity against several accounts. Leverage ratios indicate how company assets and business operations are financed. There are different types of leverage ratios, including the following five:

• Debt-to-Assets Ratio = Total Debt / Total Assets
• Debt-to-Equity Ratio = Total Debt / Total Equity
• Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)
• Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
• Asset-to-Equity Ratio = Total Assets / Total Equity

How Does Leverage in Finance Work?

An individual investor or company borrows capital so that they have to use less amount from their funds. This will increase the returns substantially. Let us understand the concept of leverage in finance through two examples.

Leverage for a business: 

• Suppose a company wants to buy a piece of land worth 50 crore rupees, and the returns from this land are calculated to be 65 crore rupees. 
• If the company pays the entire 50 crores from its account, then it will earn returns of 15 crore rupees.
• On the other hand, if the company took a loan of 40 crores, then the returns will turn into 55 crores. 

The above example explains the power of leverage. These profits will increase with time when the value of the land, i.e., the asset, becomes more than the interest on the loan. 

Leverage for an individual:

1. Suppose you want to buy 1000 shares at 500 rupees per share. 
2. To buy all these shares, you will have to pay 5 lakh rupees to the broker (considering there is no brokerage).
3. If you go for leverage, then you might borrow 3 lakh from the broker. This will help your earn more returns on the investment. 

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Why Do Businesses Use Leverage?

There are several benefits of leverage for a business. Let us understand that:

1. Businesses may use leverage for launching new projects, financing inventory purchases, and expanding their operations.
2. If a business plans to raise money through IPO, it will have to give up its ownership. In the case of debt leverage, the company does not have to lose its ownership.
3. Investors consider financial leverage and operating leverage to evaluate the business.

Advantages and Disadvantages of Debt Leverage

Leverage in finance is essential for those who want higher returns with small investments. It has both advantages and disadvantages. It is crucial to understand its application and practicality for your business and assets. 

Advantages

1. Higher returns on relatively small investments. 
2. Ability to gain more funds and assets through debt leverage. 
3. The interest amount will be tax-deductible when you take a loan, thus making leverage more beneficial.

Disadvantages 

1. Losses become huge if the loan interest amount is more than the value of the investment. 
2. When you trade with leverage, you do not actually own any assets. In the case of dividends, you will have implications on its payments if you are using a leveraged product. 

Risk management in Trading through Leverage

In the case of using leverage in trading, there are two ways of preventing losses: Stop loss and guaranteed stops. Stop-loss is an exit plan where you can attach a stop to a position below which you cannot bear losses. In some cases, such as slippage, stop loss might not work. Guaranteed losses work effectively even in case of slippage or gapping. In the guaranteed stop, you will have to pay an amount in addition to the transaction fee when the stop is triggered.