What Is Financial Leverage? The Basics For Dummies
Financial leverage in simple words is simply a way for achieving bigger results with the relatively small amount of capital/financial resources. This is usually possible with the help of credit, but leverage could also be achieved with the help of some financial instruments like derivatives. In the most common case, borrowing against the initial amount of capital is what actually leverage is. This way one increases the power of his/her money, by adding some more on credit secured by the money. It is used everywhere in the financial world and its main purpose is a greater financial result. Sometimes all of this is also referred to as gearing. For better understanding this, let’s see the following example of how leverage is used in stock trading.
Example for Financial Leverage – The Basics
Imagine that John has 100 dollars and he wants to invest his money in shares of a company called “DODO” One single share of this company is traded for 1 dollar on the market. So he can buy 100 shares of DODO for his $100. But if he goes to a stockbroker, who offers leverage 2:1, John would be able to buy 200 shares with $100, because leverage 2:1 means that for every dollar he has with the broker, she will lend him one more – He will have 2 dollars for every 1 of his. John has to pay back the full amount lent by the broker ($100) when he sells his shares. Because this is a loan, John also has to pay interest on the borrowed money as long, as he uses it.
This is the simplest example of financial leverage. But to further understand what it is, let’s continue with the example…
So, John decides to accept his broker’s leverage conditions and buy 200 shares 1$ each, using his $100 dollars and the $100 borrowed from the broker. On the next day, the price of his shares rises with 10 cents to $1,10 ( 10% rise ). John now has 200 shares X 10 cent = $20 profit after this. So he has earned twenty bucks with $100, or he has achieved a 20% return. The price goes up only 10%, but his return is 20% because of the leverage he used in his investment. This way he
earns twice as much, as he would have earned without financial leverage…
Wow! But why not use 100:1 leverage, one would probably say, this way the earnings would be 100 times more? Yes it’s true, but there is one tiny detail – leverage can increase losses the same way it increases profits.\r\n\r\nLets say on the very next day, the price of John’s shares declines with 20 cents to $0.90. Now he has 200 shares X $0.90 = 180 dollars, or he has lost 20 bucks from the beginning. If we exclude the 100 dollars which have to be repaid to his broker, John now has $80 left, which are his and has lost (-20%) from his initial deposit of $100.The price has declined only 10 percent from $1 (where he bought the shares) but he has realized a 20% loss – twice more if leverage has not been used. This is the other side of financial leverage. If the interest owed to the broker has to be included in the calculation, John’s loss would have been even greater.\r
This is only one example for the use of leverage. It could also be used in many other fields as corporate finance, forex trading (where it is called margin), other investment strategies, etc. But in all areas, it works the way described above – leverages the financial result.
In the corporate world leverage can mean different things, but in most cases, credit is involved. For instance, a business can leverage its equity (own capital) by borrowing money. The more money borrowed, the less equity capital it has relative to total assets, and this means a greater leverage ratio. This way its profits (or losses) are shared among a smaller base of equity and are proportionately larger as a result. Many big businesses (read some cool stories about them here: businessideaslab.com ) collapsed during the big financial crash of 2008, because of too much debt and a high gearing ratio, which magnified the losses.
Common financial leverage ratios and the formulas for their calculation
1. Debt Ratio = Total Liabilities / Total Assets – measures the overall leverage of a company.
2. Debt to equity ratio = Total Debt / Total Equity – measures the amount of debt compared to the amount of shareholders’ equity/capital.
3. Quick Ratio = Cash + Marketable Securities + Accounts Receivable / Current Liabilities – measures the company’s short-term liquidity.
4. Interest Coverage = Operating Income / Interest Expenses – measures to what extent the operating income can cover interest expenses.