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Reviewed by May 18, 2022| Updated on
When reading finance-related news or going through a business magazine, you must have come across many commonly used financial terms that may not have made sense at first glance if you are not already familiar with them. One such word is leverage, which many companies often use in their day-to-day business activities. Although this leverage has many benefits for the companies, the term may sometimes get confusing if you are new to the business world, and thus it becomes important to understand it in a little more detail. So, let's go through the basics of leverage and understand its importance in running a business as well as in investing.
Leverage or financial leverage is basically an investment where borrowed money or debt is used to maximise the returns of an investment, acquire additional assets or raise funds for the company. Individuals or businesses create debt by borrowing money or capital from lenders and promising to pay this debt off with the added interest. Thus, leverage can also mean trading equities. Whenever a company or an individual business is termed as highly leveraged, it means that the debt on them is more than the equity. Knowing this helps investors to make the right decisions before investing in any property, firm, or company.
A company or an individual can use leverage for many reasons, but these reasons differ from a company to an individual. In other words, a company can use leverage for various reasons like increasing the value of their assets, acquiring new equipment to increase the shareholder value, and many more. Whereas an individual investor usually uses leverage to increase the return of their investments.
Individuals who do not want to use leverage directly can do so indirectly by investing in companies that use leverage in their business activities. To understand leverage better, you must know that the value of the asset and the interest on the loan the company has borrowed are the two main factors that come into play. When and if the value of an asset increases and becomes more than the interest on the loan, the investor or company that owns the asset will get a higher return and thus experience profit. Whereas if the value of the asset decreases, the investor or company that owns the asset will experience a loss.
Given the above logic, it must generate more returns than the interest amount for the company to gain maximum profits. Companies usually plan to achieve this by using a combination of equity and debt to finance their business activities or raise funds. Therefore, for running a business individually or as a company, leverage is something that you must completely understand as it plays a major role in running the business operations. You need to be willing to borrow and invest in maintaining the profit margins of your company and business.
As with any other financial instrument, even leverage has its own advantages and disadvantages that you must know before using it for your business or individual investments. As leverage is a multifaceted financial tool, it is a little complex in nature and can enhance both gains and losses when used by a company or an individual investor. Thus, understanding its advantages and disadvantages will help you expand your business and give you an idea if your business is cut out to use this financial tool just yet.
The advantages and disadvantages of leverage are as follows:
Companies or individual businesses that borrow loans through leverage investments can make a relatively small investment.
Through this leveraged investment, these companies and businesses can buy more assets and funds for their organisation.
Suppose the asset value increases and the conditions are favourable. In that case, it benefits the borrowers greatly as they can get higher returns for their investments which will help them to stay within the profit margin.
The one risk that runs while using leverage is the loss that the companies might face if the asset value declines and goes lower than the interest that the companies have to pay on their debts.
This financial risk is especially high in certain businesses like construction, oil production, and automobile construction, which may face the highest losses if the asset value falls.
If not used properly, the leverage investment can prove fatal for businesses and can even cause companies to go out of business. This especially affects companies with less predictable income and are less profitable. This is also why many first-time investors are advised against using leverage until they have gained enough experience to avoid such a great loss to their business.
It is extremely important to keep the above advantages and disadvantages in mind and to consider all the possible risks before using a leveraged investment as a company or as an individual investor.
Now that we have discussed leverage in detail let's talk about the common confusion that most people face between leverage and margin. More often than not, these two terms are mixed up, which creates confusion for many people who are new to the business and investment world. Although the two terms are interconnected and include borrowing, these are in no way identical to each other. While margin refers to the amount of money required to open a position that depends on the margin rate requirement, leverage is the debt calculation used to get higher returns and account for equities for your business or company.
Margin can also be considered a special kind of leverage that involves using existing cash or securities positions as collateral to increase the company's buying power. The margin thus allows you to borrow money from a lender at a fixed interest rate to purchase positions, securities, and futures contracts in an attempt to reap maximum profits. This means although margin and leverage aren't exactly the same, margin can be used to create leverage to increase your buying power by a marginal amount.