In finance, leverage is a way to multiply gains. However, it also multiplies losses.
What Is Leverage?
It is the ratio of borrowed capital to equity (in other words, the ratio between the borrowed and own capital). It also refers to the effect of using borrowed funds to increase the size of operations and profits without having enough capital for this. The size of the ratio of borrowed capital to equity characterizes the degree of risk and financial stability. If, for example, a firm has significantly more debt than equity, it is considered to be highly leveraged.
Financial leverage can occur only if the trader uses borrowed funds. The borrowed capital typically costs less than the extra profit that it provides. This additional profit is summed up with the return on equity, which makes it possible to increase the rate of return. On the commodity, stock and currency markets, the concept of financial leverage is transformed into margin requirements - the percentage of the funds that a trader must have in their account to make a transaction to the total value of the transaction to be made.
The commodity market typically requires at least 50% of the total transaction amount. It means that to conclude a contract for $200, the trader must have at least $100. In the derivatives and currency exchange markets, the conclusion of, for example, a futures contract requires to make a guarantee of 2 - 15 % of the contract value. It means that to conclude a contract for $200 it is enough to actually have between $4 and $30.
Leverage vs Margin
Leverage and margin are interconnected but not the same. Leverage refers to taking on debt whereas margin is the debt or borrowed money that a company uses to invest in other financial instruments. With a margin account, traders can borrow funds from brokers for a fixed interest rate to purchase securities, options or futures contracts with the purpose of receiving high returns. It is possible to use margin in order to create leverage.
In margin trading, leverage is often written as a proportion that shows the ratio of the collateral amount to the size of a possible contract. For example, margin requirements of 20% correspond to leverage of 1: 5 (one to five), and margin requirements of 1% correspond to a leverage of 1: 100 (one to one hundred). In this case, a trader can conclude a contract that is 5 (or 100) times larger than the size of their collateral deposit.
How to Calculate Leverage
Depending on its type, leverage can be calculated by using the following formulas:
Financial: Total Debt / Shareholders’ Equity
Accounting: Total Assets / Total Assets – Total Liabilities
Notional: Total Notional Amount of Assets + Total Notional Amount of Liabilities / Equity
Economic: Volatility of Equity / Volatility of an Unlevered Instrument in the Same Assets
When to Use Leverage
Both investors and companies can benefit from leverage. Investors use it to increase the returns on investment. Companies use it to finance their assets. Instead of issuing stock to raise capital, companies can use debt financing to invest in business operations with the purpose of increasing the shareholder value. Individual investors also can use leverage indirectly, for example, by investing in companies that regularly use leverage as a part of their business.
Leverage can occur in the following situations:
Business equity owners leverage their investment by having the business borrow a portion of its needed financing. As a result, any profits or losses become proportionately larger.
In real estate finance transactions, investors leverage their savings by financing a portion of the purchase price with mortgage debt. So if they buy a property that is financed 50% by debt and 50% by equity, when they sell the house at the double purchase price, they repay
the lender not half the gain as it would have been in the case of equity financing, but only the nominal value of the loan plus interest. As a result, the investor has increased their gain by 200%. In the case of equity financing, the gain would be 100%.
Hedge funds may leverage their assets by financing a portion of their portfolios with the cash receipts from the short sale of other positions.
Businesses use fixed cost inputs to leverage their operations when revenues are expected to vary. An increase in revenue will also increase operating profit.
Mass trading with financial leverage effect can potentially result in a financial crisis. One of the clearest example of this is the collapse of the British bank Bering, one of the oldest and largest banks in the world. The financial crisis of 2007 – 2009 was also partly blamed on excessive leverage. For example, consumers in the US and other developed countries had high levels of debt as compared with their income and the value of collateral assets. When home prices fell, the borrowers could no longer afford debt payments, and lenders could not recover their principal by selling the collateral.
A leverage ratio is a financial measurement that defines how much capital comes in the form of debt or evaluates the ability of a company to meet its financial obligations. Knowing how much debt a company has can help to assess if it can pay off its debts as they become due. The most common types of leverage ratios are the debt to equity ratio, debt to capitalization ratio, consumer leverage ratio, interest coverage ratio, equity multiplier, and degree of financial leverage.
Leverage is a powerful financial tool that can help investors and companies increase their gains. However, at the same time, it also magnifies losses. Individuals use leverage to increase the return on investments, typically during the real estate finance transactions, whereas companies use it to fund their assets. It is also possible for individual investors to use leverage indirectly, for example, by investing in companies that regularly use leverage.