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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. Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. ...
Borrowing can refer to: The use of loanwords. ...
For other uses, see Debt (disambiguation). ...
The Court of Chancery, London, early 19th century This article is about the concept of equity in the jurisprudence of common law countries. ...
Types of leverage
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, not only is that money lost, but the loan still needs to be repaid. A loan is a type of debt. ...
For other uses, see Debt (disambiguation). ...
The Return on Assets (ROA) percentage shows how profitable a Companys assets are in generating revenue. ...
Interest is the rent paid to borrow money. ...
Return on Equity (ROE, Return on average common equity) measures the rate of return on the ownership interest (shareholders equity) of the common stock owners. ...
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 interest and taxes. In finance, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty. ...
Investment is a term with several closely related meanings in finance and economics. ...
The Court of Chancery, London, early 19th century This article is about the concept of equity in the jurisprudence of common law countries. ...
Ownership equity, commonly known simply as equity, also risk or liable capital, is a financial term for the difference between a companys assets and liabilities -- that is, the value that accrues to the owners (sole proprietor, partners, or shareholders). ...
For other uses, see Debt (disambiguation). ...
The debt to equity ratio (D/E) is a financial ratio indicating the relative proportion of equity and debt used to finance a companys assets. ...
The book value of an asset or group of assets is sometimes the price at which they were originally acquired (historic cost), in many cases equal to purchase price. ...
The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. ...
The operating leverage is the fixed cost operating expenses as a percentage of revenue: operating expense/revenue. ...
Earnings per share (EPS) are the earnings returned on the initial investment amount. ...
Measures of financial leverage
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: The debt to equity ratio (D/E) is a financial ratio indicating the relative proportion of equity and debt used to finance a companys assets. ...
- D / E = (A - E) / E
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. In accounting and finance, the carrying value or carry value of an asset is the amount reported as the assets current nominal worth for accounting purposes. ...
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: The Du Pont Identity (also known as Du Pont analysis or Dupont analysis) is an expression which breaks ROE (Return On Equity) into three parts. ...
- 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. The operating leverage is the fixed cost operating expenses as a percentage of revenue: operating expense/revenue. ...
EBIT stands for Earnings before Interest and Taxes (operating income). ...
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. Positive linear correlations between 1000 pairs of numbers. ...
The measure known as the Beta coefficient captures all three of the components of leverage in a single measure. The Beta coefficient is a key parameter in the Capital asset pricing model (CAPM). ...
Derivatives Derivatives allow leverage without borrowing explicitly, though the 'effect' of borrowing is implicit in the cost of the derivative. In mathematics, the derivative of a function is one of the two central concepts of calculus. ...
- 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.
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. ...
An option contract is an agreement in which the buyer (holder) has the right (but not the obligation) to exercise by buying or selling an asset at a set price (strike price) on (European style option) or before (American style option) a future date (the exercise date or expiration); and...
A call option is a financial contract between two parties, the buyer and the seller of this type of option. ...
Structured products are synthetic investment instruments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. ...
An income trust is an investment trust that holds income-producing assets. ...
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. For other uses, see Risk (disambiguation). ...
Financial engineering is the application of science-based mathematical and statistical models to make a better decision about managing financial risks, investing, borrowing, lending, and saving. ...
See also Financial engineering is the application of science-based mathematical and statistical models to make a better decision about managing financial risks, investing, borrowing, lending, and saving. ...
For other uses, see Debt (disambiguation). ...
In finance, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty. ...
Return on margin (ROM) is often used to judge financial performance because it represents the net gain or net loss compared to the exchanges perceived risk as reflected in required margin to trade financial instruments. ...
A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or bootstrap transaction) occurs when a financial sponsor gains control of a majority of a target companys equity through the use of borrowed money or debt. ...
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