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 leverage, when you might use the strategy and how to calculate it.
Types of 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, investors and other entities 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. 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.
Let’s take a look at a few instances of leverage that generally fall into the groups listed above.
Examples of 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 or properties. 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, such as the ability to live in the home, 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 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:
- 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.
- 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.
- 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).
- 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.
- Debt-to-capitalization ratio: This ratio compares a company’s total debt to its capitalization. It’s a measure of the risk a company has taken on to increase profits. The formula is debt divided by debt plus shareholder equity.
- 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 leverage
Leveraging can allow businesses and people to make investments that would otherwise be too expensive. It’s a strategy for expanding your returns and accelerating growth. And, it’s a way of using existing funds more effectively. For example, a person investing in real estate might be able to buy multiple properties and increase their returns by using several loans, rather than all cash.
For businesses, leverage can aid with investments that would otherwise be beyond their means, such as purchasing a new building or investing in new machinery, equipment or technology. Beyond that, leverage can help a business that’s running out of cash for daily operations, or experiencing a spike in sales, without the product necessary to fulfill orders. Taking on debt to fund more production can make sense for growth.
While the advantages might seem appealing, debt also comes with potential downsides.
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 item 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 them 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.
