Leverage (finance)
Leverage (or
gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. In finance, this generally refers to borrowing. If the firm's
return on assets (ROA) is higher than the interest on the loan, then its
return on equity (ROE) will be higher than if it did not borrow. On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow.
Financial leverage takes the form of a
loan reinvested with the hope to earn a greater rate of return than the cost of interest. Leverage allows greater potential return to the investor than otherwise would have been available. The potential for loss is greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid.
Margin buying is a common way of utilizing the concept of leverage in
investing. An unlevered firm can be seen as an all equity firm, whereas a levered firm is made up of
ownership equity and
debt. A firm's debt to equity ratio is therefore an indication of its leverage. This
debt to equity ratio's influence on the value of a firm is described in the
Modigliani-Miller theorem.
Another form of creating leverage using financial instruments is through the use of
options. The purchase of a
call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument.
Utilizing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. This increased
risk may be perfectly acceptable or even necessary to reach the goals of the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and securities purchases, is the subject of a discipline known as
financial engineering.
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Margin (finance)*
London Interbank Offered Rate
