Leverage
Leverage
Debt is bad, as we've all heard. However, this is not always the case. Debt can be used to build credit,
start building equity through the purchase of a new home, or even leverage it to make a profit-
generating investment.
Debt can also be referred to as leverage. Leverage is frequently used in business to refer to
borrowing funds to finance the purchase of inventory, equipment, or other assets. To finance those
purchases, businesses use leverage rather than equity.
Leveraging is when you use borrowed money - such as loans, securities, capital, or other assets - for
an investment in order to potentially increase the return on that investment. We have covered
leverage in-depth in this article below.
What is Leverage?
Leverage is an investment strategy that involves borrowing money to increase the potential return on
investment. It can be used in business, professional trading, and even to finance a home. Leverage
can also refer to the amount of debt a company uses to fund an asset, which is referred to as
financial leverage.
While leverage may increase an investment's returns, there is a drawback: if the investment does not
work out, it may increase the potential risk and loss of the investment.
Leverage is the use of borrowed capital (debt) to fund an investment or project. As a result, the
potential returns from a project are multiplied. Simultaneously, leverage multiplies the potential
downside risk if the investment does not pan out. When a company, property, or investment is
referred to as "highly leveraged," it means that it has more debt than equity.
Both investors and businesses use the concept of leverage. Leverage is used by investors to
significantly increase the returns on their investments. They leverage their investments by utilizing
various instruments such as options, futures, and margin accounts.
Companies can use leverage to finance their assets. In other words, rather than issuing stock to
raise capital, businesses can use debt financing to invest in business operations in an attempt to
increase shareholder value.
Types of Leverage
1. Operating Leverage
Operating leverage is concerned with the firm's investment activities. It refers to the incorporation of
fixed operating costs into the firm's revenue stream.
The firm can magnify the effect of changes in sales on changes in EBIT by using fixed costs. As a
result, operating leverage refers to a company's ability to use fixed operating costs to magnify the
effects of changes in sales on earnings before interest and taxes.
This leverage is related to changes in sales and profit. The more fixed operating expenses there are
in the cost structure, the greater the degree of operating leverage. The DOL is defined as the
percentage change in earnings before interest and taxes relative to a given percentage change in
sales and output.
It is an interesting fact that a change in sales volume results in a proportionate change in a firm's
operating profit due to the firm's ability to use fixed operating costs. The degree of operating
leverage should have a value greater than one.
● A high degree of operating leverage magnifies the effect of a small change in sales volume
on EBIT.
● High operating leverage is caused by a higher proportion of fixed costs in a firm's total cost
structure, resulting in a low margin of safety.
● High operating leverage indicates that more sales are required to reach the break-even point.
● A higher fixed operating cost in a firm's total cost structure promotes higher operating
leverage and risk.
● Lower operating leverage provides a sufficient cushion to the firm by providing a high margin
of safety against sales variation.
2. Combined Leverage
Total fixed charges are incurred by a company in the form of fixed operating costs and fixed financial
charges. Operating leverage is concerned with operational risk and is quantified by DOL. Financial
leverage is associated with financial risk and is quantifiably expressed by DFL.
Fixed charges are a concern for both leverages. When we combine these two, we get the total risk of
a firm, which is associated with the firm's total leverage or combined leverage. The risk of not being
able to cover total fixed charges is primarily associated with combined leverage.
The ability of a company to cover the sum of its fixed operating and financial charges is referred to
as combined leverage. The percentage change in EPS to a given percentage change in sales is
referred to as the Degree of Combined Leverage (DCL).
DCL is a quantitative expression for combined leverage. The greater the proportion of fixed
operating costs and financial charges, the greater the degree of combined leverage. The value of
combined leverage, like the other two leverages, must be greater than one.
● High operating leverage combined with high financial leverage is a very risky situation
because the sum of the two leverages is a multiple of these two leverages
● A combination of high operating leverage and low financial leverage indicates that
management should exercise caution because the high risk associated with the former is
offset by the latter.
● Because keeping the operating leverage at a low rate allows full use of debt financing to
maximize return, a combination of low operating leverage and high financial leverage
provides a better situation for maximizing return and minimizing risk factors.
In this case, the firm achieves its break even point while maintaining a low level of sales and
a low level of business risk.
● Low operating leverage combined with low financial leverage indicates that the firm is
missing out on profitable opportunities.
3. Finance Leverage
Financial leverage is primarily related to a firm's capital structure's mix of debt and equity. The
presence of fixed financial charges in the firm's income stream causes financial leverage.
As a result, financial leverage can be defined as a company's ability to use fixed financial charges to
magnify the effects of changes in EBIT on EPS. The greater the proportion of fixed charge-bearing
funds in a firm's capital structure, the greater the Degree of Financial Leverage (DFL), and vice versa.
DEL is a quantitative expression of financial leverage. Degree of Financial Leverage is defined as the
percentage change in earnings per share to a given percentage change in earnings before interest
and taxes (DFL).
● It aids the financial manager in developing an optimal capital structure. The optimal capital
structure is the combination of debt and equity that results in the lowest overall cost of
capital and the highest firm value.
● A high level of financial leverage indicates the presence of high financial fixed costs as well
as high financial risk.
● It displays the excess of the return on investment over the fixed cost of using the funds.
● It is a useful tool in the hands of the finance manager when determining the amount of debt
in the firm's capital structure.
Working capital investment has a significant impact on a company's profitability and risk. A
decrease in current asset investment leads to an increase in firm profitability and vice versa.
Because current assets are less profitable than fixed assets, this is the case. Reduced investment in
current assets raises the volume of risk. Risk and return are inextricably linked.
As a result, as risk rises, so does the firm's profitability. Thus, Working Capital Leverage (WCL) can
be defined as the firm's ability to magnify the effects of changes in current assets on the
firm's Return on Investment (assuming current liabilities remain constant) (ROI).
Advantages and Disadvantages of Leverage
As with any other financial instrument, leverage has advantages and disadvantages that you should
be aware of before employing it in your business or personal investments.
Because leverage is a multifaceted financial tool, it is somewhat complex in nature and can increase
both gains and losses when used by a business or an individual investor. Understanding its benefits
and drawbacks will help you expand your business and determine whether your company is ready to
use this financial tool just yet.
❖ Advantages:
The most significant advantage of leverage is that it increases the liquidity available
to the company because when a company takes out a loan or debt, it receives cash
from the lender, and that cash can be used for a variety of activities.
Another advantage of leverage is that in the case of a growing company that requires
cash for its operations, the use of debt can result in a multiplication of profits for the
company.
This is because the cost of debt is between 8 and 15%, whereas the rate of profits in
the case of a growing company can range from 20% to 100%. As a result, as long as
the company is growing, leverage tends to magnify the company's profits.
Another advantage of leverage is that companies that do not want to dilute their
ownership can use this route of financing because in the case of debt financing or
loan, the company must repay the principal amount on maturity along with periodic
interest and there is no risk of giving equity to anyone, resulting in complete control
of the company by the company's owners.
❖ Disadvantages :
The most significant disadvantage of leverage is that there is a risk that a company
will use too much leverage, which can lead to problems for the company because
there will be no benefit to taking leverage beyond an optimum level of leverage.
As a result, companies that earn average or below-average profits can use leverage
to do more harm than good. This financial risk is particularly high in certain
industries, such as construction, oil production, and automobile construction, which
may suffer the greatest losses if asset values fall.
When leverage investment is not used properly, it can be fatal to businesses and
even cause them to fail. This is especially true for businesses that have less
predictable income and are less profitable.
This is also why many first-time investors are advised to avoid using leverage until
they have gained sufficient experience to avoid such a significant loss to their
business.
So, what exactly is leverage? Leverage is the ratio applied to the margin amount to determine how
large trade will be placed. Understanding margin and leverage, as well as the distinction between the
two, can be difficult at times.
It is critical to understand that margin is the amount of capital required to open a trade. Find out
more about margin accounts. Leverage of 10:1 means that the required margin to open and maintain
a position is one-tenth of the transaction size.
As an example, if a trader wanted to make a Rs 10,000 trade on a financial asset with a 10:1
leverage, the margin requirement would be Rs 1,000. It is critical for all traders to be aware of the
risks associated with leveraged trading.
Novice traders should exercise extreme caution when practicing margin trading. It is best to be more
cautious and use less leverage.
Conclusion:
Borrowing money enables businesses and individuals to make investments that would otherwise be
out of reach, or to use their existing funds more efficiently. Individuals may find that using leverage is
the only way to afford certain large-ticket items, such as a home or a college education.
While leverage has a lot of upside potential, it can also end up costing you a lot more than you
borrowed, especially if you can't keep up with interest payments.
This is especially true if you invest money that isn't your own. Leverage, at least when it comes to
investing, should be reserved for seasoned pros until you have experience—and can afford to lose
money.