Leverage (finance)

In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.

Financial leverage
Financial leverage takes the form of a loan or other borrowings (debt), the proceeds of which are reinvested with the intent to earn a greater rate of return than the cost of interest. If the firm's return on assets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow. On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential return to the investor than otherwise would have been available. The potential for loss is also greater, because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying is a common way of utilizing the concept of leverage in investing. An unlevered firm can be seen as an all-equity firm, whereas a levered firm is made up of ownership equity and debt. A firm's debt to equity ratio (measured at market value or book value, depending on the purpose of the analysis) is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem. As is true of operating leverage, degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (Earnings per share) that occurs as a result of a percentage change in earnings before interest and taxes.

Debt-to-equity
Debt to equity is generally measured as the firm's total liabilities (excluding shareholders' equity) divided by shareholders' equity, where D = liabilities, E = equity and A = total assets:
 * D / E = Debt-to-equity ratio

D / (D + E) = Debt-to-value ratio

For different applications of leverage, analysts may include or exclude certain items, such as non-tangible balance sheet items, non-financial liabilities, and similar items, or may adjust the carrying value of other items. It is not uncommon to use only financial liabilities (long-term and short-term borrowings), thereby excluding, for example, accounts payable.

Gearing and Du Pont Analysis
Use of the Du Pont Identity requires that leverage be measured in terms of total assets divided by shareholders' equity (which is further decomposed in the traditional analysis), and this is sometimes referred to as gearing or simply leverage:
 * Leverage (gearing) = A / E

The two measures are related. Since the terms used are the same throughout, debt-to-equity is equal to gearing times debt over assets (as the asset term cancels out):
 * D / E = (A / E) * (D / A)

Operating leverage
Operating leverage reflects the extent to which fixed assets and associated fixed costs are utilized in the business. Degree of operating leverage (DOL) may be defined as the percentage change in operating income that occurs as a result of a percentage change in units sold. To the extent that one goes with a heavy commitment to fixed costs in the operation of a firm, the firm has operating leverage.

Combined stand-alone leverage
If both operating and financial leverage allow us to magnify our returns, then we will get maximum leverage through their combined use in the form of combined leverage. Operating leverage affects primarily the asset and operating expense structure of the firm, while financial leverage affects the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations, while financial leverage determines how the “fruits of labor” will be divided between debt holders (in the form of payments of interest and principal on the debt) and stockholders (in the form of dividends). Degree of combined leverage (DCL) uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings per share. Degree of operating leverage and degree of financial leverage are, in effect, being combined.

Correlation leverage
Correlation leverage is a third concept that captures the degree to which the variability in the firm's revenue is correlated with that of other firms. If the correlation is low or negative, investors who hold a diversified portfolio will not see that variability as bad, and the firm will be able to carry a higher level of combined stand-alone leverage than if the variability in its revenue were highly correlated with that of other firms.

The measure known as the Beta coefficient captures all three of the components of leverage in a single measure.

Derivatives
Derivatives allow leverage without borrowing explicitly, though the 'effect' of borrowing is implicit in the cost of the derivative.
 * Buying a futures contract magnifies your exposure with little money down.
 * Options do the same. The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument.
 * Structured products that exist as either closed-ended funds, or public companies, or income trusts are responding to the public's demand for yield by leveraging. This is frequently not disclosed anywhere other than far down in the Prospectus.

Risk
Employing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Interest and principal payments (usually certain ex ante) may be higher than the investment returns (which are uncertain ex ante). This increased risk may still lead to the optimal outcome for the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and security purchases, is the subject of a discipline known as financial engineering.