Have you ever wondered what the term ‘leverage’ really means? You’ve heard of it a bunch of times, but somehow you never knew the exact definition of it? Don’t worry. You are not the only one. We are here to give you all the necessary information to help you understand leverage in the best possible way.
Leverage is an investment strategy where one uses borrowed money, capital of various financial instruments to increase the potential return of their investment. In other words, leverage results from using borrowed capital as a funding source. It happens when investing in expanding the firm’s assets and generating returns on capital risk.
It refers to the ratio of a company’s loan debt (capital) to the value of its ordinary shares. Simply put, it’s the amount of debt that one company uses to finance assets.
So, what is the concept of leverage?
The concept of leverage – explained.
When it comes to the concept of leverage, companies and investors are using it very often. The reason why investors are using leverage is to increase the returns that are provided on some investments. These investments are levered by numerous instruments, which includes margin accounts, options, and futures.
On the other hand, many firms and companies are using leverage to finance their assets. So, instead of raising capital by issuing stock, many companies are now using debt financing to invest in many business operations. That all happens in an attempt to increase the value of a shareholder.
What about investors who are uncomfortable using leverage?
For these investors who are not comfortable using leverage directly, there are many ways to access power indirectly. How is that possible?
Investors can invest in companies using leverage in the ordinary course of business to expand operations or finance without increasing their outlay.
How do you know the difference between leverage and margin?
Even though both leverage and margin are interconnected because they involve borrowing, they are far from the same. The main difference between leverage and margin is that leverage is referring to taking on debt. On the other hand, the margin is known as the borrowed money or debt that one firm uses to finance other financial instruments.
It’s crucial to understand that one uses margin to create leverage. The margin account is there to allow you to borrow money from a broker for a fixed interest rate to purchase futures contracts, options, or securities to receive very high returns.
A simple example of leverage
Here is a simple example of leverage:
One firm forms a company with $3 million investments from investors. The equity in the firm is $3 million, which they can use for operating. If the firm uses debt financing by borrowing $15 million, they now have $18 million. They are allowed to invest in many opportunities and business operations to increase the shareholder’s value.
For example, an automaker is about to borrow money for their new factory. That factory would enable that automaker to increase the number of produced cars and increase their profits.