| leverage The use of fixed costs in order to increase the rate of return from an investment. One example of leverage is buying securities on margin. While leverage can operate to increase rates of return, it also increases the amount of risk inherent in an investment. See also financial leverage, operating leverage. |
2. The amount of debt that has been used to finance activities. A company with much more debt than equity is generally called "highly leveraged." Too much leverage is thought to be unhealthy, but many firms use leverage in order to expand operations.
Leverage. Leverage is an investment technique in which you use a small amount of your own money to make an investment of much larger value. In that way, leverage gives you significant financial power.
For example, if you borrow 90% of the cost of a home, you are using the leverage to buy a much more expensive property than you could have afforded by paying cash.
If you sell the property for more than you borrowed, the profit is entirely yours. The reverse is also true. If you sell at a loss, the amount you borrowed is still due and the entire loss is yours.
Buying stock on margin is a type of leverage, as is buying a futures or options contract.
Leveraging can be risky if the underlying instrument doesn't perform as you anticipate. At the very least, you may lose your investment principal plus any money you borrowed to make the purchase.
With some leveraged investments, you could be responsible for even larger losses if the value of the underlying product drops significantly.
The effect borrowed money has on an investment;the concept of borrowing money to buy an asset that will appreciate in value, so that the ultimate sale will return profits on the equity invested and on the borrowed funds.
Example: Mark and Amy each have $100,000 to invest. They can buy rental houses for $100,000 per house and collect rent of $1,100 per month for each house. At the end of 5 years, they will be able to liquidate and sell their houses for $150,000 each. Amy uses leverage and Mark does not.
What Does Leverage Mean?
(1) The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
(2) The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered highly leveraged.
Investopedia explains Leverage
(1) Leverage can be created through options, futures, margin, and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, or you could increase your leverage by buying five option contracts worth $1,000. You then would control 500 shares instead of 10. (2) Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, a company started with an investment of $5 million from investors has equity of $5 million; this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders. Leverage helps both the investor and the firm invest and operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would have been if the investment had been made with cash; leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default can destroy shareholder value.
Related Terms:
• Debt Ratio
• Deleverage
• Leveraged Buyout—LBO
• Margin
• Operating Leverage
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