Financial Dictionary -> Investing -> Leverage

Financial instruments, such as futures, margins and options , are used to create financial leverage. Borrowed capital is used to enlarge the potential return of an investment. Leverage refers to the amount of debt used to finance the assets of a company. If the company has a considerable amount of more debt than equity or assets, it is thought to be highly leveraged.

Most of the time when leverage is used, it is used to finance a company's operations. Many times this pays off by giving the company the capital it needs to invest in business operations without enlarging its equity. Using financial leverage enables a company to increase value for its shareholders.

Financial leverage can help both the investors in the business and the business itself. However, one drawback is that using leverage does come with some risk. If a loss occurs, the loss is greater if the investment has been leveraged. When using leverage a company is risking shareholder value but often the benefits outweigh the risk.

Financial leverage is used when a company's directors intend to earn a greater rate of return than the cost of interest on their borrowings or debt. Investors in companies who use leverage will enjoy greater returns if the leverage pays off. However, if the cost of interest exceeds the rate of return to investors, they will suffer a loss of value in the company and their investment may become worthless. If the company does experience a loss, they are still obligated to pay their loan principals and all accrued interest on those loans in full.

There are differences in companies that are leveraged as opposed to those which are not. Leveraged companies are often referred to as a company made up of debt and ownership equity. A company which is not leveraged is viewed as an all-equity company.

The effect of financial leverage of a company can be measured oftentimes by whether or not economic conditions are favorable. Other factors would be whether the firm used only long-term and short-term loans for leverage or if it used accounts payable as well. Another factor to consider is how much or how large the percentage is of leveraging.

If the returns are magnified by both operating and financial leverage, the financial leverage will be maximized. If only financial leverage is used, it only affects the debt to equity ratio; however, utilizing operating leverage will affect mainly the operating expenses and assets of the company.