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Leverage: Definition and Use in Investing

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Leverage

Leverage is a common financial concept you may often hear in reference to maximizing investor returns. Commonly used by investors and companies alike, leverage is a technique that utilizes debt instead of equity to buy an asset. The expectation is that the profit from the endeavor will exceed the risk and cost of taking on additional debt. However, applying leverage to your investment strategy comes with pros and cons. If you have further questions, meet with a financial advisor in your area.

What Is Leverage Investing?

Leverage is an investment strategy that uses borrowed capital to increase the potential returns of an investment. More specifically, an investor will borrow money as a funding source instead of using their own equity. Investors use this strategy in an effort to multiply their gains and, in turn, grow their overall asset base.

Just like many other strategies, leveraging investments comes with risk. While leveraging assets has the potential to heavily increase your returns, it can similarly multiply your losses. If the investment results in a loss that exceeds the income from the asset or the value of the asset plummets, an investor could find themselves in a troublesome financial situation.

How to Use Leverage Investing

Leverage

If an investor wants to take on a project or an investment, they may use debt to purchase this investment. Essentially, instead of issuing stock to raise capital to fund certain business operations, a company can use debt financing to increase shareholder value.

Let’s assume a company’s equity is $6 million. That company may want to utilize its funds for operating costs. Therefore, if the company wants to invest in additional business operations, but not use its equity, it can use debt financing to extend its assets. So if the company decides to finance $15 million, it now has $21 million to invest as opposed to just $6 million.

As another example, let’s say an appliance retailer wants to open a new location via leverage financing. Because the new location could increase appliance sales and market reach, the appliance retailer can justify financing the purchase instead of using its equity. Basically, the appliance retailer is banking on being able to grow the company without dipping into its own assets.

Investors can also apply this investment strategy by using different tools, such as options, futures and margin accounts. However, if an investor is risk-averse or doesn’t feel confident using leverage, there are options available to leverage their investments indirectly. This involves investing in companies that leverage their business endeavors without increasing their expenditures.

Evaluating Financial and Operational Leverage

There are several ways investors can evaluate a company’s use of leverage. First, it’s important to assess its debt-to-equity ratio (D/E). This is the most common evaluation of a company’s leverage. As an investor, you could also review the interest coverage ratio, which measures the status of the company’s interest payment obligations.

Additionally, many investors evaluate the degree of operating leverage and financial leverage as a fundamental analysis. Investors can calculate operational leverage by dividing the company’s change in earnings per share by its percentage change in its earnings prior to interest and taxes. A higher degree of operating leverage demonstrates a higher level of volatility within the company.

When evaluating financial leverage, or the equity multiplier ratio, investors should divide the company’s total assets by its equity. Once you determine this number, you can then multiply the financial leverage with total asset turnover and profit margin to yield the return on equity.

For instance, if a company has $400 million in total assets, as well as $150 million in shareholder equity, then the equity multiplier is 2.66 ($400 million  $150 million). This equation illustrates that the company has financed over half of its equity.

Using these ratios will help you determine if a company is neglecting potential opportunities to accelerate earnings or if it’s taking on too much risk. Investing in a company that is well-leveraged may help you grow your own profits and assets.

However, if evaluating these company records is not your expertise, you may want to explore other investment options. You could consider mutual funds or exchange-traded funds (ETFs) that apply leverage to their investment strategy. By purchasing these investment vehicles, you can indirectly delegate the research to savvy investment experts.

Downsides of Leverage Investing

Leverage

Taking on too much leverage can result in a negative outcome. While there are no specific rules, guidelines or amount of leverage that’s technically unacceptable, it’s important to be responsible when using it. Leverage is a powerful tool that, when used correctly, can help investors and companies grow their assets mutually.

Smart investors and companies alike use leverage to expand their investment fund pools. However, overly aggressive leverage investment strategies can result in significant loss of funds or even worse, bankruptcy.

Bottom Line

Using leverage responsibly has the potential to increase your profits. But if used incorrectly, you could face financial hardship. If you want more guidance when it comes to investing or other areas surrounding your financial health, you may want to consider joining forces with a financial advisor.

Investing Tips
  • If you’re new to investing, it might be helpful to work with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with top financial advisors in your area in 5 minutes. If you are ready to be matched with a local advisor that will help you achieve your financial goals, get started now.
  • Before jumping into investing, you should come up with a personal asset allocation. This involves planning what percentage each type of investment will occupy within your overall portfolio. This should be in accordance with your risk tolerance level. To get a head start on this process, stop by SmartAsset’s asset allocation calculator.

Photo credit: iStock.com/SusanneB, iStock.com/utah778, iStock.com/kate_sept2004

The post Leverage: Definition and Use in Investing appeared first on SmartAsset Blog.

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