Investing for Beginners , investing

Leverage definition

In finance leverage means usage of debt capital in addition to the equity capital in order to increase the profit. Increase in leverage is understood as increase in riskiness and volatility.

Leverage in Investment

Employment of leverage is quite common among investors, especially the professional ones. This tool is used to buy more securities with less equity capital. There are few instruments that allow doing it, for example, buying on margin (margin trading), repo contracts or other forms of borrowing that are suited to buy more stock or other investments using debt. Borrowed capital gets especially popular during long lasting bull market when everybody forgets about the fear, and as a rule, after the period of strong stock market decrease, there are very few leverage users left in the market, and withdrawing the capital from the markets causes further drops of the indices.  

Leverage is even more widely used in some untraditional investment fields as Forex market or by hedge funds. Currency traders use very high leverage which makes the fluctuations of currency rates very significant. While there are many types of hedge funds, most of them use various financial instruments and debt capital is one of those. 

Using traditional investments together with some derivatives may have the same effect as using leverage because financial engineering allows achieving any desired result. Basically, financial leverage increases the volatility of the investment portfolio which causes higher profit or loss depending on the market conditions. If market will stay flat for a long period, investor will suffer losses in reality because he will have to pay interest for borrowed capital. 

Leverage in Corporate Finance

1. Financial leverage usually is called only ‘leverage’ and means usage of debt capital to finance company’s business. The capital sources of each company can be classified to equity capital, debt capital or mixed capital (as mezzanine financing). The higher share of debt capital in capital structure means higher leverage of the company. If company doesn’t have any borrowed capital or it is insignificant, such company is unleveraged. 

• Measurement of the leverage: there is no single formula to determine company’s financial leverage level but many financial ratios can be used to measure the leverage: D/E ratio (can be calculated in book value or market value terms) compares debt capital to equity capital, D/EBITDA ratio compares debt to EBITDA (type of earnings) and may be even more important. Basically, leverage means increased riskiness and riskiness of the company depends on many factors, and because of this real riskiness cannot be measured applying one ratio.

• Target capital structure is the best tool to determine what leverage ratio is optimum. If company is using too much debt, it may be at danger and it might increase cost of capital. If company is using too little of debt, then it won’t create maximum value for shareholders while equity capital will not be employed efficiently.

• M&A markets are the ones where leverage is as much natural as acquisitions are. In the reality, most of the large M&A deals are using difficult payment schemes which include some level of leverage. 

2. Operating leverage is another type of leverage which has nothing to do with debts but still is related to the riskiness. Basically, it shows the EBIT sensitivity in relation to the volatility of company’s sales. If company will have a lot of fixed costs, its operating leverage should be high.