leverage

Finance

(noun)

The overall debt divided by shareholder equity. This borrowing allows for the multiplication of gains and losses.

Related Terms

  • capital structure
  • insolvency
  • financial leverage
  • overleveraged
  • EBIT (earnings before interest and taxes)
  • cost of capital
  • derivative

(noun)

The ability to utilize something to gain more of something else.

Related Terms

  • capital structure
  • insolvency
  • financial leverage
  • overleveraged
  • EBIT (earnings before interest and taxes)
  • cost of capital
  • derivative

(noun)

The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).

Related Terms

  • capital structure
  • insolvency
  • financial leverage
  • overleveraged
  • EBIT (earnings before interest and taxes)
  • cost of capital
  • derivative

(noun)

Debt taken on by a firm in order to finance assets.

Related Terms

  • capital structure
  • insolvency
  • financial leverage
  • overleveraged
  • EBIT (earnings before interest and taxes)
  • cost of capital
  • derivative
Business

(verb)

To use in such a way to capture maximum value.

Related Terms

  • exploitation
  • foreclosures
  • derivatives
  • consumerism
  • perishable
  • credit crunch
  • receivable
  • inventory
  • integration
  • monetary policy
  • Homogeneous
  • asset
  • isolationist
Management

(noun)

A technique used to multiply gain or loss.

Related Terms

  • Synergy
  • incentives
  • interpersonal skills
Physics

(noun)

A force amplified by means of a lever rotating around a pivot.

Related Terms

  • mechanical advantage
  • machine
Economics

(noun)

The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return, but usually at high risk.

Related Terms

  • Bank Run

Examples of leverage in the following topics:

  • Combining Operating Leverage and Financial Leverage

    • To calculate total leverage, we multiply Degree of Operating Leverage by Degree of Financial Leverage.
    • Operating and financial leverage can be combined into an overall measure called "total leverage. " Total leverage can be used to measure the total risk of a company and can be defined as the percentage change in stockholder earnings for a given change in sales.
    • Total leverage can be determined by a couple of different methods.
    • Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.
    • TL = Total Leverage.
  • Impacts of Financial Leverage

    • At an ideal level of financial leverage, a company's return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.
    • However, if a company is financially over-leveraged a decrease in return on equity could occur.
    • The most obvious risk of leverage is that it multiplies losses.
    • On the other hand, when debt is taken on for personal use there is no value being created, i.e., no leveraging.
    • There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage.
  • Financial Leverage

    • Common ways to attain leverage are borrowing money or buying derivatives.
    • A business entity can leverage its revenue by buying fixed assets.
    • In terms of investments, there exists accounting leverage, notional leverage, and economic leverage.
    • The most obvious risk of leverage is that it multiplies losses.
    • There also exists the risk of involuntary leverage.
  • Defining Operating Leverage

    • Operating leverage is a measure of how revenue growth translates into growth in operating income.
    • Therefore, companies with low output would not benefit from increased operating leverage.
    • Therefore, operating leverage is used much more than financial leverage for these types of firms.
    • Operating leverage also increases forecasting risk.
    • Various measures can be used to interpret operating leverage.
  • Benefits and Risks of Operating Leverage

    • Leverage, in general, can defined as any technique that is used to multiply gains and losses.
    • By this definition the use of leverage creates risk, and thus will always necessitate a tradeoff between risk and return.
    • In other words, a company with higher operating leverage has the potential to generate much larger profits than a company with lower operating leverage.
    • Just as the use of operating leverage can lead to greater profits, if a company is able to reach a given, break-even point, so too can the use of leverage drastically multiply losses if that point is not reached.
    • Identify the types of companies that would benefit from higher operating leverage
  • Defining Financial Leverage

    • At its simplest, leverage is a tactic geared at multiplying gains and losses.
    • The standard definition of financial leverage is as follows:
    • In short, the ratio between debt and equity is a strong sign of leverage.
    • This results in a financial leverage calculation of 40/60, or 0.6667.
    • Before Lehman Brothers went bankrupt, they were leveraged at over 30 times ($691 billion in financial leverage compared to $22 billion in assets).
  • Leverage Models

    • Models that allow us to interpret appropriate financial leverage include the Modigliani-Miller theorem and the Degree of Financial Leverage.
    • Further, value may be added by utilizing leverage.
    • Financial leverage can be measured, or defined, using certain ratios.
    • The higher the Degree of Financial Leverage, the riskier the business.
    • Financial leverage is defined as the ratio of operating income to net income.
  • Influential Observations

    • The former factor is called the observation's leverage.
    • Observation B has small leverage and a relatively small residual.
    • Observation C has small leverage and a relatively high residual.
    • Observation D has the lowest leverage and the second highest residual.
    • Observation E has by far the largest leverage and the largest residual.
  • Leverage Models

    • The relationship between fixed and variable costs, when calculated alongside sales volume, enables modeling of operational leverage.
    • Before learning each calculation, it's useful to frame the issue of leverage first.
    • Operating leverage is largely predicated on fixed costs.
    • Most of the calculations and models for leverage are relatively intuitive when looking at examples.
    • At the core of degree of operating leverage is the same concept discussed in the example above.
  • Financial Structures

    • Understand how to qualify and leverage financial incentives through the Small Business Administration (SBA).
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