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Leverage

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Leverage

  1. 1. LeverageThe use of debt financing, or property of rising or falling at a proportionally greateramount than comparable investments. For example, an option is said to have highleverage compared to the underlying stock because a given price change in thestock may result in a greater increase or decrease in the value of the option. Also,commonly known as Gearing in Europe.Leverage1. To use debt to finance an activity. For example, one usually borrows money inthe form of a mortgage to buy a house. One commonly speaks of this as leveragingthe house. Likewise, one leverages when one uses a margin in order topurchase securities.2. The amount of debt that has been used to finance activities. A company withmuch more debt than equity is generally called "highly leveraged." Too muchleverage is thought to be unhealthy, but many firms use leverage in order to expandoperations.Leverage. Leverage is an investment technique in which you use a small amountof your own money to make an investment of much larger value. In that way,leverage gives you significant financial power.For example, if you borrow 90% of the cost of a home, you are using the leverageto buy a much more expensive property than you could have afforded by payingcash.If you sell the property for more than you borrowed, the profit is entirely yours.The reverse is also true. If you sell at a loss, the amount you borrowed is still dueand the entire loss is yours.Buying stock on margin is a type of leverage, as is buying a futures or optionscontract.
  2. 2. Leveraging can be risky if the underlying instrument doesnt perform as youanticipate. At the very least, you may lose your investment principal plus anymoney you borrowed to make the purchase.With some leveraged investments, you could be responsible for even larger lossesif the value of the underlying product drops significantlyLeverageThe effect borrowed money has on an investment; the concept of borrowing moneyto buy an asset that will appreciate in value, so that the ultimate sale will returnprofits on the equity invested and on the borrowed funds.Example: Mark and Amy each have $100,000 to invest. They can buy rentalhouses for $100,000 per house and collect rent of $1,100 per month for eachhouse. At the end of 5 years, they will be able to liquidate and sell their houses for$150,000 each. Amy uses leverage and Mark does not.LeverageWhat Does Leverage Mean?(1) The use of various financial instruments or borrowed capital, such as margin, toincrease the potential return of an investment.(2) The amount of debt used to finance a firms assets. A firm with significantlymore debt than equity is considered highly leveraged.Investopedia explains Leverage
  3. 3. (1) Leverage can be created through options, futures, margin, and other financialinstruments. For example, say you have $1,000 to invest. This amount could beinvested in 10 shares of Microsoft stock, or you could increase your leverage bybuying five option contracts worth $1,000. You then would control 500 sharesinstead of 10. (2) Most companies use debt to finance operations. By doing so, acompany increases its leverage because it can invest in business operations withoutincreasing its equity. For example, a company started with an investment of $5million from investors has equity of $5 million; this is the money the companyuses to operate. If the company uses debt financing by borrowing $20 million, thecompany now has $25 million to invest in business operations and moreopportunity to increase value for shareholders. Leverage helps both the investorand the firm invest and operate. However, it comes with greater risk. If an investoruses leverage to make an investment and the investment moves against theinvestor, his or her loss is much greater than it would have been if the investmenthad been made with cash; leverage magnifies both gains and losses. In the businessworld, a company can use leverage to try to generate shareholder wealth, but if itfails to do so, the interest expense and credit risk of default can destroy shareholdervalue.LEVERAGE RATIOS Debt to Assets Ratio = Total Liabilities/Total Assets Debt to Equity Ratio = Total Liabilities/Total Equity Times Interest Earned = Operating Income/Interest ExpenseA leverage ratio is a comparison of a combination of a companys debt, equity,assets and interest payments to ascertain its long-term solvency and ability to meetits financial obligations. Leverage, or gearing, refers to the use of loans or otherforms of debt to finance acquisitions or investments. The goal of using thesefinancing options is to earn a higher rate of return than the rate of interest on theloan and amplify gains. Companies with a high degree of leverage are consideredrisky and highly vulnerable to economic downturns because they must continue tomeet obligations to the debt in spite of poor production or sales.The three most commonly employed leverage ratio formulae are the debt-to-equityratio, thedebt ratio, and interest-coverage ratio. Acceptable leverage ratios aredetermined by comparison to ratios of other entities in the same industry. They arealso determined by tracking of the same ratio for one company over time.AdChoices
  4. 4. The debt-to-equity ratio is the most commonly used leverage ratio, providing ameasure of a companys liabilities in relation to the funds given by shareholders. Agreater proportion of shareholder capitalization provides a safety net and is viewedas a sign of financial strength. This ratio is calculated by dividing the total debts bythe total equity of the shareholders. The lower the number, the less gearingor leverage that the company is using. Since the leverageratio is used to assesslong-term solvency, many companies deduct the accounts payable, a short-termdebt, from the total debt figure before completing the ratio calculation.Another type of leverage ratio, the debt ratio or debt-to-asset ratio, indicates whatportion of the companys assets is financed by debt. The debt ratio is determined bydividing the companys total debts by its total assets. A higher debt ratio signifies ahigher degree ofleverage used by the company. The operating liabilities are oftendeducted from the total debts before calculating the ratio.Alternatively, the interest-coverage ratio indicates the relative ease with which acompany can pay the interest associated with its debt. The formula divides theamount earned per share by the interest expenses, before interest and taxes aresubtracted from the earnings. In general, an interest-coverage ratio of less than twois a red flag that the company may be unable to fulfill its interest obligations.This ratio is monitored as a critical indicator of a companys viability since even adeeply indebted company may be able to make its interest payments. Oncethis ratio falls, default or bankruptcy may be imminent.

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