Meaning of Leverage in Finance
Leverage meaning differs under many tongues. It sounds different in the world of real estate, cynical in the world of politics and significantly in the financial markets. Each has its connotations.
Here we would be talking about leverage in the financial world. Or more importantly in the Stock Market.
The basic definition of leverage would be that it is an investment strategy whereby borrowed money is used to increase the potential of an investment. In other words, magnify the returns. It is akin to using a lever to move a heavyweight.
Hence, when an item is termed as leveraged, it would mean that the amount of debt is higher than equity.
It is pertinent to remember that though both are linked to borrowing, Leverage and Margin are not the same.
Margin allows one to create leverage but not the other way around. Leverage simply amplifies returns on the premise of using debt. While the margin is using debt to buy assets or investing.
What is Financial Leverage?
Financial leverage is defined as the method to acquire or control a larger amount of assets through the usage of debt, to amplify the returns.
When the value of the asset increases, the owner will end up with a larger gain. But this can only happen if the rate of interest of the loan is lower than the rate of increase in the value of the asset.
However, there is a downside to it too. Imagine the reverse happening.
If the value of the asset falls and goes below the rate of interest of the loan, then the loss gets amplified.
Hence, leverage has its inherent risks as much as its advantages.
The Financial Leverage formula looks like this:
Leverage = total debt of company/equity of shareholder
Now, if you had to calculate the short and the long term debt, then the formula would be:
Total debt incurred = Short Term Debt + Long Term Debt
What are the types of Leverages?
There are two types of leverages: Financial and Operational
Operating Leverage: The ability of an individual or a company to used fixed cost to generate greater returns
Financial Leverage: The ability of the individual or the firm to reduce costs and also amplify returns by paying lower taxes
There is a third kind of Leverage meaning that props up here. It is called Combined Leverage.
Combined Leverage = Financial Leverage + Operational Leverage
In simple terms, Operational leverage is all about fixed costs and how well they are managed while Financial Leverage is all about different capital structures and going for the one which reduces the taxes the most.
They both reflect the inherent essence of the leverage meaning.
There are some inherent differences between Operating leverage and financial leverage. Let us have a quick look at them:
| Operating Leverage | Financial Leverage |
| It is more about Fixed costs | It is all about capital structures |
| It measures the operating risk of the entity | It deals with the financial risks of the entity |
| The DOL or Degree of Operating Leverage highlights the degree or severity of Operating risk. If DOL is high than Operating risk is high and vice versa. | Similarly, DFL highlights the financial risk of the entity. If it’s high then there is a higher degree of the financial risk involved and vice versa. |
| Operational Leverage is higher than the Break-Even Point | Financial leverage, on the other hand, has a direct relationship with the balance sheet’s liability side |
| Operational Leverage is always preferred to be lower | Financial Leverage is always preferred to be higher. |
| Operational Leverage = Contribution/EBIT | Financial Leverage = EBIT/EBT |
Now the question is can an entity exist by using both the leverages. The quick answer to that is Yes.
It is primarily a wrangle between fixed costs and capital structures and if played well, the entity can very well look for higher returns at reduced costs.
The leverage meaning stands tall in the world of Finance. In the stock market, leverages work well when one is margin trading. The inherent risks are offset by benefits and most investors are willing to play a part in it.
Conclusion
Leverage is a great way to increase returns based on borrowed money or in trade parlance Debt. However, leverage meaning applies to both profit and loss. If on one hand, it amplifies profit, if there is a downturn it will amplify the losses too. The bottom line is to be cautious. Play on.
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Leverage FAQs
1: Is leverage meaning the same as Margin?
Ans: Though they are both based on debt or borrowing, there is an inherent difference. In Margin, you would need to borrow a certain amount of money to invest in an asset. With leverage, you will be able to amplify your returns.
2: Is Leverage risky?
Ans: Yes. It is risky. It is a process where you are using debt to amplify returns. There is always a possibility of returns not meeting expectations or even failing. Then the entire transaction will turn into a loss. Higher the leverage, the greater the risk.
3: Can Margin be used to leverage?
Ans: Absolutely. Margins are used to create leverages. However, it is not true vice versa.
4: How many types of Leverages are there?
Ans: There are primarily two different types of leverages: Operational Leverages and Financial Leverages. Operational Leverage uses fixed costs to amplify returns while Financial Leverage relies more on capital structures and reduced taxes to generate greater returns.
