What is Leverage?

Leverage.

We all have heard about it. But what is it?

To some, it's owning a significant amount of information that the other negotiating party involved doesn't have.

To others, it's a more financial based system where individuals and/or companies find borrowed funds for investment purposes.

A simple example of financial leverage:



Say you have $10 that you want to invest in a stock. If you invest that $10 and it goes up 10%, you’ve made $1. However, if you’re able to borrow an additional $90 to purchase that stock, you’d have $100 total to invest. If that stock goes up 10%, you’ve made $10. This is leverage: borrowing money to magnify returns. (Of course, losses are magnified as well.)

A home mortgage is a common example of leverage in practice. In general, a homebuyer has only a small amount of the purchase price. Most of the money for the transaction is borrowed from a bank. House prices tend to increase with time. By using leverage to purchase a house, we’re able to magnify our return on equity.


So how do you calculate leverage?

We use leverage ratios*.

Leverage ratios look at the extent that a company has depended upon borrowing to finance its operations.

Most leverage ratios compare assets or net worth with liabilities. A high leverage ratio may increase a company's exposure to risk and business downturns, but along with this higher risk also comes the potential for higher returns. Some of the major measurements of leverage include:

Debt to equity ratio: Debt / Owners' Equity—indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt to equity ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution. In general, debt should be between 50 and 80 percent of equity.

Debt ratio: Debt / Total Assets—measures the portion of a company's capital that is provided by borrowing. A debt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt. This ratio is similar, and can easily be converted to, the debt to equity ratio.

Fixed to worth ratio: Net Fixed Assets / Tangible Net Worth—indicates how much of the owner's equity has been invested in fixed assets, i.e., plant and equipment. It is important to note that only tangible assets are included in the calculation, and that they are valued less depreciation. Creditors usually like to see this ratio very low, but the large-scale leasing of assets can artificially lower it.

Interest coverage: Earnings before Interest and Taxes / Interest Expense—indicates how comfortably the company can handle its interest payments. In general, a higher interest coverage ratio means that the small business is able to take on additional debt. This ratio is closely examined by bankers and other creditors.


How does leverage affect you and me?

Leverage can have varying affects. But an example of how leverage affects us is the situation we're in right now; The Financial Crisis of 2007-2010. A while back, I explained the Hyman Minsky's Financial Instability Hypothesis. In this post I mention how banks became over-leveraged (over-indebted) during good times and were basically unable to pay their investors.

You can also read a great post about the Minsky Moment from the New Yorker.

Other Notes on Leverage:
In macroeconomics, a key measure of leverage is the Debt-to-GDP ratio (A measure of a country's federal debt in relation to its gross domestic product (GDP)).

Now you know about leverage. So take your calculator and add up ALL of your debts(credit cards, student loans), then divide this number by your assets (home, car, investments and the value of that 1967 Les Paul)...

...are you over-leveraged?

*Leverage ratios courtesy of www.referenceforbusiness.com