What Is Financial Leverage? Types, Formulas and Examples
Financial leverage is a means by which companies or individuals go into debt to purchase an asset, such as a house or equipment for a factory. Understanding financial leverage, including both its advantages and risks, can help you know when and how to use it. If you're interested in a career in finance or business, learning more about financial leverage may help you succeed. In this article, we explain ‘What is financial leverage?', explore its advantages and disadvantages and provide useful financial formulas.
What is financial leverage?
Financial leverage is the use of debt, not equity, to increase the potential return on investment. Any individual or company may use leverage to purchase an asset that they otherwise couldn't. A family may use leverage in the form of a mortgage to purchase a house. An investor or company may use leverage to increase their power to buy assets and multiply their returns.
Financial leverage is beneficial when the debt generates returns that are greater than the loan's interest expenses associated with the loan. An example of this is if the factory a company purchases produces a profit that outweighs the repayment of the debt. A company can measure its financial leverage through a debt-to-equity formula, which calculates the ratio of total debt to total assets. If a company has high leverage, it has significantly more debt than equity, and this can increase the risk of failure and increase the potential returns of a business. Anyone who can access a loan may use financial leverage. This could include the following:
entrepreneurs, such as chief executive officers (CEOs) or founders of start-ups
small and large businesses
any other individual with enough income to take out a loan
Why use financial leverage?
Financial leverage can increase returns or produce a profit that otherwise may not exist. Often, it can be more effective for a company to purchase an asset with debt than with equity. For instance, one company may purchase an asset with 100% equity, and another company may purchase the same asset with 40% equity and 60% debt. If the asset appreciates equally, each can expect to receive the same profit, but the second company has a higher return on investment (ROI). A higher ROI means that the second company can make the same profit with a smaller initial investment.
Taking out a loan instead of raising capital or selling assets can help start-ups and small businesses. The loan allows owners to pay for the initial costs of starting the business until they make a profit. Firms may also use leverage to avoid diluting shares. By using debt to finance business operations instead of issuing shares, an owner can maintain ownership of the company and increase shareholder value.
Advantages of financial leverage
The advantages of using financial leverage may include the following:
Buying potential: A business may purchase more assets through debt.
Increased profits: In favourable conditions, financial leverage can produce higher returns than if an individual or business raises their own funds and pays outright.
Opportunities: Taking out an initial loan can offer a secure way to start a new business venture.
Investments: Investments allow individuals to purchase assets, such as a house, that they otherwise may not.
Challenges of financial leverage
The challenges of using financial leverage may include the following:
Market volatility: A change in interest rates or a decline in return from assets may make it difficult to offset interest expenses.
Short-term gain: Certain assets may quickly decline in value.
High risk: It can be a complex and risky way to increase profit, especially for new investors.
Uncertain rewards: While it has the potential to produce significant gains, it can also magnify losses.
Types of financial leverage
There are several types of financial leverage that an individual or company may use, including the following:
Financial leverage specifically refers to a business that takes on debt to buy assets. The business expects the assets to produce profits that exceed the cost of the borrowed money. Financial leverage can offer benefits to a business that wants to avoid selling equity to raise money or has minimal assets. Borrowers may use a loan to expand their operations, buy materials or equipment or start new business ventures.
Investors may use leverage if they want to invest more than they can afford with their available cash. The term for this is ‘buying on the margin', and it allows investors to increase their returns but only if their investments perform better than the cost of the loan itself. For example, an investor who buys on the margin may control $100,000 worth of securities with $50,000 of their own money. As investors can incur considerable losses (and gains) through this strategy, newer and less experienced investors typically buy on the margin.
Leverage for personal finances
Individuals may also use leverage to make large, one-off purchases. They may take out a loan to purchase an asset such as a car or to grow their capital in the future. For instance, an individual might go into debt to invest in a house, which is likely to increase in value. They may also take out a loan to invest in a side business, which has the potential to produce a profit and give them the capital they otherwise may not have.
Leverage in professional trading
This is a similar strategy to buying on the margin but offers more significant returns and higher risk. It can increase traders' ability to purchase shares by allowing them to take on higher levels of borrowed capital. Professional investors often have higher limits on the capital they borrow and may not follow the same requirements as non-professionals. This kind of leverage generally demands a high level of knowledge, depth of experience and the acceptance of significant risk.
Examples of financial leverage
The following are examples of how an individual or company may use financial leverage to their advantage:
Leverage for personal finances
Here's an example of how an individual may have several personal finances:
You have $200 of your own money and borrow $2,000 from the bank at an interest rate of 6%. You decide to invest all $2,200 in an investment, which grows by 15% in a year. By the end of the year, the value of the investment is $2,530. You return the borrowed money plus interest at the end of the year, which is $2,000 + $120, leaving you with $410. Once you subtract the initial $200 investment from your own money, this leaves you with a net gain of $210.
Leverage for a company
Here's an example of how a company can use leverage:
A company uses $100,000 of its own cash and a loan of $900,000 to buy a new factory worth a total of $1 million. The factory generates $150,000 in annual profit. The company uses financial leverage to generate a profit of $150,000 on a cash investment of $100,000. This means a 150% return on its investment.
Financial leverage formulas
Financial formulas can help determine how efficient a company is at producing profit relative to its debt, equity or assets. Investors may also use ratios to determine which business they decide to buy shares in. The following are some common formulas:
Leverage ratio or debt-to-equity ratio
Debt-to-equity ratio = total debt ÷ total equity
This ratio evaluates a company's financial leverage by calculating the proportion of debt to equity. A higher ratio may show that there's more use of creditor financing (debt) than of positive assets like shareholder's financing, profitability and net income. For example, if the leverage ratio is 2, this means that a company uses $2 in debt for every $1 of equity. The company's debt level is 150% of equity.
Return on equity (ROE)
ROE = net income / equity
This formula measures the profitability of a business in relation to its equity. An investor may use ROE statistics to determine how a company deploys capital and how much of the capital it borrows. Companies typically consider an ROE of around 14% to be acceptable.
Return on assets (ROA)
ROA = net income / total assets
ROA shows how profitable a company is in relation to its total assets. Corporate management, analysts and investors may use ROA to determine how efficiently a company uses its assets to generate a profit. A higher ROA means that a company is more efficient at managing its balance sheet to generate profits.
Earnings per share (EPS)
EPS = net income / number of shares
EPS is the monetary value of earnings per outstanding share of common stock for a company. It can show how much money a company makes for each share of its stock and is a metric to estimate corporate value. A high EPS indicates a company with greater value: investors are likely to pay more for its shares if they believe the company has higher profits relative to its share price.