What is Financial Leverage? – A Brief Guide

Finance is quite a broad term, and within this term, there are many terms that you need to take your time to figure out what they mean in their entirety. Terms like financial leverage, which you may have heard in some entrepreneurial context, may still be a mystery to you.

Well, financial leverage essentially means to use borrowed capital to fund your expansion plans or even a start-up. It’s more or less an investment strategy that a number of corporates use to achieve their long or short term expansion plan. It’s a key plan to increase the potential return on your investment.

In some scenarios, you can term leverage as debt – a debt to finance assets for some companies. To understand what financial leverage is and what it actually represents, read on. Info on how you can use leverage to expand your business and the special consideration about leverage can also be found here.

What is Financial Leverage? - A Brief Guide
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Breaking Down Leverage

When you’re undertaking an investment project, you obviously need some sort of capital. If you don’t have it, that’s when leverage comes in as it is a sort of borrowed capital or debt. The result is therefore to multiply the potential returns of the project for which the leverage is used for.

But you have to watch out that as much as leverage is meant to multiply the potential return, it also multiplies the potential downside. This, however, is when the investment doesn’t go as well as you had initially planned.

So, what does it mean when you hear that a company is “highly leveraged”? It simply means that the company has more debt than it has equity. This can be for companies, investments, and properties. And when it comes to investors, they can use leverage to the returns that can be provided by their investment.

How Investors & Companies Use Leverage

Companies have stock, which can leave you wondering that why do they need leverage in the first place? Well, companies use leverage to finance their assets for long term gain, in most cases. So, instead of using stocks to raise capital, they use leverage in their business operations.

This is also an attempt by the company to increase its shareholder value. For investors, the process is pretty much the same and for those who aren’t clear about using leverage straight up, they can use indirect routes for the same result.

For example, they can invest in companies that use leverage in their normal course of business operations.

Leverage vs. Margin

Margin is like the distant cousin of leverage, and you need to know how they intertwine. First of all, these two revolve around borrowing, they aren’t the same thing in depth.

If you borrow for the sole purpose of increasing your portfolio, this is leverage – it’s straight-up borrowing. Then you have a margin where you borrow from a broker at a fixed rate. This money is borrowed to invest in securities, futures contracts, etc.

This is done in anticipation of high returns from what you used the borrowed amount to invest in. In conclusion, you can use margins to create leverage, as they differ in the process but do relate.

What is Financial Leverage? - A Brief Guide
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Disadvantages of Leverage

When you think of leverage as most people do, they only think of the upside when the return is actually high. But what happens when you make a wrong call and it doesn’t go the way you had earlier expected it to?

The idea can go the reverse way here – opposite of your initial anticipation of a great return. Leverage can magnify the gains, so, expect it to do the same when it comes to losses.

Conclusion

Leverage is one of the terms that you really need to be familiar with if you’re looking to get into the business. It’s how you can make a major move and bet big on your company or investment and can magnify your gain.

However, you need to be extra careful, because if you make the wrong turn with regard to what you were looking to invest in, it will also manifold the losses.