Leverage

What is Leverage?

Leverage is the strategic use of borrowed money (debt) to increase the potential return on investment, acquire assets, or fund business operations. It enables individuals and businesses to amplify their financial capacity and pursue growth opportunities beyond what their existing capital would allow.

When an entity is described as highly leveraged, its debt is more significant than its equity, which gives an idea of its financial structure. Leverage can be a very effective tool but also poses substantial risks.

How Leverage Works

1. For Businesses:
   • Using leverage, a company can buy new equipment, enhance productivity, or maximise shareholder value.
   • These days, very few companies have been able to create a sound capital structure without combining equity and debt financing.
2. For Individuals:
   • Investors use leverage to increase their returns on investments.
   • If you don’t have direct leverage, you can get indirect exposure by investing in leveraged companies.
3. Key Factors:
   • The conditions of the underlying asset determine the effectiveness of leverage:
     • When the asset's value goes above the loan's interest cost, it amplifies profits.
     • In some cases, asset value declines can compound losses to a point where they are higher than the initial investment.

Advantages of Leverage

1. More Buying Power: Leverage allows you to buy more or invest with little to no capital.
2. Higher Returns: When the stars align, leverage can magnify returns and increase profits.
3. Business Growth: You can use leverage to grow your business, invest in technology or enter new markets and grow long term.

Disadvantages of Leverage

1. More Risk: A drop in asset value below the interest rate of the debt can be a big loss.
2. Industry Specific Vulnerability: Construction, oil production and automotive manufacturing sectors are more vulnerable due to asset value fluctuations.
3. Insolvency: Misuse of leverage can lead to cash flow issues and push businesses into bankruptcy.
4. Complexity for New Investors: First-time investors may struggle to manage leverage and lose more money.

How Leverage Differs From Margin

Leverage and margin are closely related concepts but serve distinct purposes:

• Leverage: Refers to the broader use of debt to increase financial capacity and returns.
• Margin: A type of leverage where you use existing cash or securities as collateral to borrow money to buy more securities or futures contracts.

In other words, a margin is a form of leverage where the borrowed money is tied to collateral.