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In finance
Finance

The field of finance refers to the concepts of time, money and risk and how they are interrelated. Banks are the main facilitators of funding through the provision of credit, although private equity, mutual funds, hedge funds, and other organizations have become important....
, leverage (or gearing) is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt
Debt

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
, so as to attempt to increase the returns to equity
STOCK

Software for fixed assets management and stock control developed in 2004. Stocktaking process is carried using a hand-held mobile terminal equipped with barcode reader or RFID technology....
. Deleveraging is the action of reducing borrowings.

ncial leverage (FL) takes the form of a loan
Loan

A loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the wiktionary:lender and the wiktionary:borrower....
 or other borrowings
Debt

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
 (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest.






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In finance
Finance

The field of finance refers to the concepts of time, money and risk and how they are interrelated. Banks are the main facilitators of funding through the provision of credit, although private equity, mutual funds, hedge funds, and other organizations have become important....
, leverage (or gearing) is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt
Debt

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
, so as to attempt to increase the returns to equity
STOCK

Software for fixed assets management and stock control developed in 2004. Stocktaking process is carried using a hand-held mobile terminal equipped with barcode reader or RFID technology....
. Deleveraging is the action of reducing borrowings.

Types of leverage


Financial leverage

Financial leverage (FL) takes the form of a loan
Loan

A loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the wiktionary:lender and the wiktionary:borrower....
 or other borrowings
Debt

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
 (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets
Return on assets

The return on assets percentage shows how profitable a company's assets are in generating revenue.ROA can be computed as:This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from each dollar of assets they control....
 (ROA) is higher than the rate of interest
Interest

Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money , or, money earned by deposited funds .Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft finance, and even entire factories in finance lease arrangements....
 on the loan, then its return on equity
Return on equity

Return on Equity measures the rate of return on the ownership interest of the common stock owners. It measures a firm's efficiency at generating profits from every dollar of shareholders' equity ....
 (ROE) will be higher than if it did not borrow because assets = equity + debt (see accounting equation
Accounting equation

The basic accounting equation is the foundation for the double-entry bookkeeping system.It shows how assets were financed: either by borrowing money from someone or by paying your own money ....
). On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor than otherwise would have been available but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying
Margin (finance)

In finance, a margin is collateral that the holder of a position in security , Option , or futures contracts has to deposit to cover the credit risk of his counterparty ....
 is a common way of utilizing the concept of leverage in investing
Investing

In economics, investing is the active redirecting resources from being consumed today so that they may create benefits in the future; the use of assets to earn income or profit.Investing is the process of making an investment in order to earn a profit, for example equity investment either through a fund, a 401k plan, or individually....
. An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firm is made up of ownership equity
Ownership equity

In accounting terms, after all liability are paid, ownership equity is the remaining interest in assets. If valuations placed on assets do not exceed liabilities, negative equity exists....
 and debt
Debt

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
. A firm's debt to equity ratio
Debt to equity ratio

Preferred shares can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares....
 is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem
Modigliani-Miller theorem

The Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed....
. As is true of operating leverage
Operating leverage

The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of Leverage , and of how risky a company's operating income is....
, the degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (earnings per share
Earnings per share

Earnings per share are the earnings returned on the initial investment amount.In the US, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income....
) that occurs as a result of a percentage change in earnings before interest and taxes.

Measures of financial leverage

Debt-to-equity
Debt to equity is generally measured as the firm's total liabilities divided by shareholders' equity. In the following, D = liabilities, E = equity, A = total assets, EBIT = Earnings before interest and taxes
Earnings before interest and taxes

In financial and business accounting, earnings before interest and taxes is a measure of a firm's profitability that excludes interest and income tax expenses....
 and Interest = Interest payment:
Debt-to-equity ratio =


Debt-to-value ratio = = Debt-to-assets


Interest coverage ratio =


Degree Of Financial Leverage (DFL)
Financial Leverage affects the EPS
Earnings per share

Earnings per share are the earnings returned on the initial investment amount.In the US, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income....
 of the firm. Financial Leverage acts as a double-edged sword. If the economic conditions are favorable and EBIT
Earnings before interest and taxes

In financial and business accounting, earnings before interest and taxes is a measure of a firm's profitability that excludes interest and income tax expenses....
 is increasing, a higher financial leverage has a positive impact on the EPS. The DFL captures this relationship between EBIT and EPS. DFL is defined as the percentage change in EPS for a given percentage change in EBIT.

Symbolically,


For different applications of leverage, analysts may include or exclude certain items, such as non-tangible balance sheet items, non-financial liabilities, and similar items, or may adjust the carrying value
Book value

In accountancy, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset....
 of other items. It is not uncommon to use only financial liabilities (long-term and short-term borrowings), thereby excluding, for example, accounts payable.

Gearing and Du Pont Analysis
Use of the Du Pont Identity
Du Pont Identity

DuPont analysis is an expression which breaks ROE into three parts....
 requires that leverage be measured in terms of total assets divided by shareholders' equity, and this is sometimes referred to as gearing or simply leverage:
Leverage (gearing) = A / E


The two measures are related. Since the terms used are the same throughout, debt-to-equity is equal to gearing times debt over assets:

Operating leverage

Operating leverage
Operating leverage

The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of Leverage , and of how risky a company's operating income is....
 reflects the extent to which fixed assets and associated fixed costs are utilized in the business. Degree of operating leverage (DOL) may be defined as the percentage of leveraging.

Combined stand-alone leverage

If both operating and financial leverage allow us to magnify our returns, then we will get maximum leverage through their combined use in the form of combined leverage. Operating leverage affects primarily the asset and operating expense structure of the firm, while financial leverage affects the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations, while financial leverage determines how the “fruits of labor” will be divided between debt holders (in the form of payments of interest and principal on the debt) and stockholders (in the form of dividends). Degree of combined leverage (DTL) uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings per share. Degree of operating leverage and degree of financial leverage are, in effect, being combined.

Correlation leverage

Correlation leverage is a third concept that captures the degree to which the variability in the firm's value is correlated
Correlation

In probability theory and statistics, correlation indicates the strength and direction of a linear relationship between two random variables....
 with the variability of the universe of all risky assets.

Derivatives

Derivatives
Derivative (finance)

Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else . The underlying on which a derivative is based can be an asset , an index , or other items ....
 allow leverage without borrowing explicitly, though the "effect" of borrowing is implicit in the cost of the derivative.
  • Buying a futures contract
    Futures contract

    In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality at a certain date in the future, at a price determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders...
     magnifies your exposure with little money down.
  • Options
    Option (finance)

    In finance, an option is a contract between a buyer and a seller that gives the buyer the right?but not the obligation?to buy or to sell a particular asset at a later time at an agreed price....
     do the same. The purchase of a call option
    Call option

    A call option is a financial contract between two parties, the buyer and the seller of this type of Option . It is the option to buy shares of stock at a specified time in the future.Often it is simply labeled a "call"....
     on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument. Generally speaking, a put option allows the holder (owner), the investor, to achieve inverted-leverage and/or inverted enhancement--- sometimes called inverse enhancement and/or inverse leverage.
  • Structured product
    Structured product

    A structured product is generally a pre-packaged investment strategy which is based on Derivative , such as a single Security , a basket of securities, Option , Index , commodities, debt issuances and/or foreign currencies, and to a lesser extent, swaps....
    s that exist as either closed-ended funds, or public companies, or income trusts are responding to the public's demand for yield by leveraging.


Risk and overleverage


Employing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Interest and principal payments (usually certain ex-ante
Ex-ante

The term ex-ante is a neo-Latin word meaning "before the event". Ex-ante is used most commonly in the commercial world, where results of a particular action, or series of actions, are forecast in advance....
) may be higher than the investment returns (which are uncertain ex-ante).

This increased risk
Risk

Risk is a concept that denotes the precise probability of specific eventualities. Technically, the notion of risk is independent from the notion of value and, as such, eventualities may have both beneficial and adverse consequences....
 may still lead to the optimal outcome for the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and security purchases, is the subject of a discipline known as financial engineering
Financial engineering

Financial engineering can refer to:* Computational finance* Financial reinsurance...
.

There are economic periods when optimism
Optimism

Optimism is an outlook on life such that one maintains a view of the world as a positive place, or one's personal situation as a positive one. It is the philosophical opposite of pessimism....
 incites to a widespread and excessive use of leverage, what is called overleverage. One of its forms, associated to the subprime crisis, was the practice of financing homes with no or little down payment, playing on the hope that the price of the assets (the property in this case) will rise. Another form involved the five largest U.S. investment banks, which borrowed funds to invest in mortgage-backed securities, increasing their leverage between 2003-2007 (see diagram). During September 2008, the five largest firms either went bankrupt (Lehman Brothers
Lehman Brothers

Lehman Brothers Holdings Inc. was a global financial services corporation that, until declaring bankruptcy in 2008, did business in investment banking, Stock and Bond sales, market research and stock trading, investment management, private equity, and private banking....
), were bought out by other banks (Merrill Lynch
Merrill Lynch

Merrill Lynch & Co., Inc. is a global financial services firm which was acquired by Bank of America. This article describes both the historical Merrill Lynch and its ongoing operations as a subsidiary of the bank....
 and Bear Stearns
Bear Stearns

The Bear Stearns Companies, Inc. based in New York City, was one of the largest global investment banks and security trading and stock broker firms prior to its sudden collapse and distress sale to JPMorgan Chase in March 2008....
) or changed to commercial bank holding companies, subjecting themselves to leverage restrictions (Morgan Stanley
Morgan Stanley

Morgan Stanley is a global financial services provider headquartered in New York City, New York, United States. It serves a diversified group of corporations, governments, financial institutions, and individuals....
 and Goldman Sachs
Goldman Sachs

The Goldman Sachs Group, Inc., or simply Goldman Sachs , is a bank holding company that engages in investment banking, Security services, and investment management....
).

Negative gearing

Negative gearing
Negative gearing

Negative gearing is a form of leverage speculation in which a Speculation borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan....
 is a form of financial leverage where an investor
Investor

An investor is any party that makes an investment.The term has taken on a specific meaning in finance to describe the particular types of people and companies that regularly purchase stock or Bond Security for financial gain in exchange for funding an expanding company....
 borrows money to buy an asset
Asset

In business and accounting, assets are everything of value that is owned by a person or company. It is a claim on the property your income of a borrower....
, but the income generated by that asset does not cover the interest
Interest

Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money , or, money earned by deposited funds .Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft finance, and even entire factories in finance lease arrangements....
 on the loan. A negative gearing strategy can only make a profit if the asset rises in value and creates enough future capital gains to cover the shortfall between the income and interest that the investor suffers. The investor must also be able to fund that shortfall until the asset is sold. The tax treatment of interest expenses and future gain will also affect the investor's final return.

Math Example

Calculate equity return given:

5% Projected Return on Investment 4% Cost of Debt 8:1 Leverage Debt:Equity

LONG-FORM MATH

Investment (8+1) * 5% = 45 less Interest (8) * 4% = 32 equals Equity 1 * 13%= 13

SHORT-FORM GENERIC CALCULATION

Interest Rate Differential (5-4) = 1% Debt to Equity Multiple (8/1) = 8 Multiply Line1 * Line2 (1*8) = 8% Add Investment Return + 5% Equals Total Return (8+5) = 13%

See also

  • Coupon leverage
    Coupon leverage

    Coupon leverage, or leverage factor, is the amount by which a reference rate is multiplied to determine the floating interest rate payable by an inverse floating rate note....
  • Debt
    Debt

    Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned....
  • Leveraged buyout
    Leveraged buyout

    A leveraged buyout occurs when a financial sponsor acquires a controlling interest in a company's ownership equity and where a significant percentage of the purchase price is financed through leverage ....
  • Margin (finance)
    Margin (finance)

    In finance, a margin is collateral that the holder of a position in security , Option , or futures contracts has to deposit to cover the credit risk of his counterparty ....


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