Posted in Finance, Accounting and Economics Terms, Total Reads: 668
Leverage may mean the use of different financial instruments to potentially increase the returns of an investment. Leverage may also mean the amount of debt taken in order to finance the assets of the firm and is expressed as a ratio of the amount of debt to capital (Capital is the sum of long term debt and total shareholder’s equity). Financial leverage is also given as the ratio of total assets to the shareholder’s equity.
Higher the risk, higher is the potential risk and reward for the shareholders. Leverage can be increased by using financial instruments like futures, options and margin. For financing large capital projects, companies mostly use debt. Thus, the company increases its leverage because the company can invest in its operations without raising its equity. Let us suppose the company uses $10 million of debt and $5 million of equity to finance a capital project, and then the company uses a leverage of 0.67 for this project.
The main advantages of using leverage includes
• Helps the firm as well as the investor to invest and operate. It results in sharing of risk between the firm and the investor.
• Leverage magnifies both gains as well as the losses. The investor would be more interested in knowing about the liquidity and solvency of the company unlike the equity holders who are more interested in knowing about the profitability of the company
• A company that can successfully use its leverage demonstrates that it has the ability to honor debt obligation. Hence this improves its credit rating.
• Leverage can also increase the economies of scale of operations for the company. The borrowed funds must be paid in relatively small installments over a long period of time. This frees the free cash flow for more immediate use