What is Leverage?

Published by Thomas Herold in Investments, Trading

'Leverage' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Where business and finance are concerned, leverage pertains to the concept of using investment capital, revenue, or equity to multiply any gains or losses realized. Leverage can be affected in various ways. Among the most popular means of achieving it are through purchasing fixed assets, borrowing money, or utilizing derivatives.

There are several important examples to the use of leverage. With investments, hedge funds work with derivatives to leverage their capital. They could do this by putting up one million dollar cash for their margin and using it to control twenty million dollars of crude oil. They then realize any and all gains or losses achieved by the twenty million dollar crude position.

Businesses may similarly achieve leverage on their revenue by purchasing fixed assets. In so doing, the business would boost its proportion of fixed costs. Any change in revenue would then lead to a greater change in the associated operating income.

Publicly traded corporations are also able to obtain leverage on their stock share holder equity through borrowing money. The greater amount of cash that they borrow, the lower amount of equity capital they will require. This translates to all profits and losses being distributed out to a smaller share holder base, making them proportionately bigger in the end.

There are formulas for the four main types of leverage. Accounting leverage is found by taking all assets and dividing them by all assets minus all liabilities. Notional leverage is found by taking all notional quantities of assets, adding them to all of the notional liabilities, and then dividing the result by equity. To find the economic leverage, the equity volatility has to be divided by the identical assets’ unlevered investment volatility. Finally, operating leverage can be calculated through taking the revenue in question and subtracting out the variable cost, then dividing the operating income into the result.

Leverage entails significant benefits and also substantial risks. While it does allow potentially great amounts of money to be made when investments go the way of an individual or organization, it can also involve devastating losses when the investments move against the entity. As an example, a stock investor who purchases stocks with fifty percent margin will double his losses when a stock goes down. Companies that borrow excessively to increase their leverage can experience collapse and bankruptcy in a downturn in business at the same time as a company with less leverage could survive.

Not all uses of leverage entail the same degree of risk. Corporations that borrow money so that they can engage in international expansion, increase their line up of products, or modernize their plants and equipment gain additional diversification. This could provide more than just an offset for the extra risks that result from the leverage. Not all highly leveraged companies are risky either. Public utilities commonly include high levels of debt, but they are generally considered to be less risky than are technology companies that lack leverage.

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The term 'Leverage' is included in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.