Financial Leverage
Financial leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money or buying derivatives. Examples include:
- A public corporation may leverage its equity (stocks outstanding) by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.
- A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income .
Measuring Leverage
The term "leverage" is used differently in investments and corporate finance, and has multiple definitions in each field. In terms of investments, there exists accounting leverage, notional leverage, and economic leverage. Accounting leverage is total assets divided by the total assets minus total liabilities (or total equity). Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity. Economic leverage is the volatility of an asset divided by volatility of an unlevered investment in the same assets.
Leverage In Corporate Finance
The concept of financial leverage is much more utilized and understood in the realm of corporate finance. Financial leverage tries to estimate the percentage change in net income for a one percent change in operating income. It involves the use of debt instruments over equity instruments to acquire additional assets, therefore keeping stakeholders at a minium and per share profits at a maximum. It is possible to over-leverage, which is incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments in order to maximize returns.
Leverage and Risk
The most obvious risk of leverage is that it multiplies losses. A corporation that borrows too much money might face bankruptcy during a business downturn, while a less-levered corporation might survive. There is an important implicit assumption, though, in evaluating the risk of leverage, which is that the underlying levered asset is the same as the unlevered one. If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage.
From an investor's point of view, if an individual uses a fraction of his or her portfolio to purchase derivatives and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, plus a limited downside. In short, while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. For example, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.
There is a popular prejudice against leverage rooted in the observation that people who borrow a lot of money often end up in unfavorable situations. However, individuals who undertake such positions are not typically undertaking leverage. Instead, they are borrowing money for personal consumption. In finance, the general practice is to borrow money to buy an asset with a higher return than the cost of borrowing.
There also exists the risk of involuntary leverage. This is a situation in which a company or individual enters into financial distress and is forced to enter into a higher leveraged position. This multiplies losses as things continue to go downhill. This can lead to rapid ruin, even if the underlying asset value decline is mild or temporary.