Leverage

leverage
Leverage

A good definition for leverage could be:

–          The use of various financial instruments or borrowed capital, such as margin, to increase the potential return on investment.

–          The amount of debt, used to finance the firm’s assets. Firm with significantly bigger debt than its own equity, is considered to be highly indebted.

The leverage is most commonly used in real estate transactions through the use of mortgages for a house purchasing.

Investopedia.com gives the following leverage definition:

–          Leverage can be created through options, futures, margin and other financial instruments. For example, you have $ 1 000 to invest. This amount can be invested in 10 shares of the Funds Microsoft, but to increase the leverage, you could invest $ 1 000 in five options contracts. Then you will control 500 shares instead of just 10.

–          Most companies use debt to finance operations. In this way, the company increases its leverage, because it can invest in business operations without increasing its equity. For example, if you have a company set up with an investment of $ 5 million from investors, the private equity of the company is 5 million dollars – these are the money that the firm uses to work. If the company uses debt financing via loans worth $ 20 million, the company now has $ 25 million to invest in business operations and more opportunities to increase profits for shareholders.

The leverage helps the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would be if the investment had not been leveraged – leverage increases both profits and losses. In the business world, a company could use leverage to try to generate wealth for shareholders, but if it fails to do so, the interest expenses and the credit risk of default, destroy shareholder value.

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