Leverage: A Simple Explanation

What Does It Mean?

Leverage refers to using borrowed money (debt) or fixed costs to amplify the potential returns on an investment. In the context of businesses, leverage is often associated with loans or bonds a company takes on to fund its operations, expansions, or acquisitions. For investors, leverage can involve using margin (borrowed funds) to buy more stocks or other assets.

Types of Leverage

• Financial Leverage: Borrowing money to invest in a business or asset. For example, a company might take out a loan to build a new factory.

• Operational Leverage: Using fixed costs like machinery or rent to boost profits when revenue grows. For instance, a factory with high fixed costs but steady sales growth will see profits increase more rapidly.

• Investment Leverage: Investors use tools like margin accounts to borrow money and invest more than they could with their own capital.

An Example of Leverage

Imagine you have $10,000 to invest. You could buy 100 shares of a stock priced at $100 per share. However, if you borrow another $10,000, you can buy 200 shares. If the stock price rises to $120, your profit is $4,000 instead of $2,000 because you controlled more shares. But if the price falls to $80, your losses double as well, from $2,000 to $4,000.

Risks of Leverage

• Increased Debt: Too much leverage can leave a company or investor struggling to repay loans, especially if revenue or asset values drop.

• Higher Volatility: Leverage amplifies market movements. Small changes in asset prices can lead to significant gains or losses.

• Financial Stress: In downturns, highly leveraged companies or investors may face insolvency if they cannot meet their financial obligations.Subscribe and receive your free Ebook

Key Takeaways

• Leverage allows companies and investors to amplify their potential returns by using borrowed money or fixed costs.

• It comes with increased risks, as losses can grow quickly if things go wrong.

• To use leverage effectively, it’s important to understand both the risks and the rewards.

Leverage can be a valuable tool for growth, but it must be used carefully. In Value Investing, understanding a company’s leverage is essential to assessing its financial health and risk level. Too much leverage can signal danger, while well-managed leverage can indicate growth potential.

The information is provided for educational purposes only and does not constitute financial advice or recommendation and should not be considered as such. Do your own research.