What is financial leverage?
Financial leverage is also known as trading on equity or simply leverage. It’s when you use debt (borrowed money) to purchase an asset — or, in the case of shorting a stock, selling an asset — because you expect any resulting returns from your investment will exceed the cost of borrowing. However, the higher the leverage, the higher the ratio of borrowed funds to equity. As leverage increases, it can become more difficult to repay the debt.
The thought of debt might make you cringe. But investors and businesses can use debt as a tool to increase their holdings and generate income. Borrowing money to buy more assets than you could on your own can amplify your returns. When the asset generates income or its value rises, your return is higher because you were able to purchase more of the asset with the borrowed funds.
Leverage works the other way, too. If an asset you purchased using your own money falls in value, you can only lose as much as you spent. But if you borrow to invest in an asset, it’s possible to lose money and still owe the debt.
How financial leverage works
Both investors and companies can use leverage to acquire investments. A company might use financial leverage to buy another company because it believes owning the other company will make them more money than it costs to service the debt of the purchase. An investor might use financial leverage to borrow money for buying more shares of a stock than they could with their own cash.
Investors can access financial leverage through various investment tools like margin accounts, futures, options, or bank loans such as lines of credit or term loans.
Likewise, companies can access financial leverage through various means, including borrowing from banks or issuing corporate bonds.
In order to confidently take on financial leverage, a company or investor should feel good about two things:
1) The asset will earn enough that they can repay the debt; and 2) The value of the asset won’t fall significantly (because if it did, they could lose their own money and have to repay the debt).
Though any investment comes with some level of risk, if the asset doesn’t meet these conditions to start with, then taking on financial leverage can be even riskier. If an individual investor is over leveraged using a margin account, for example, they will face a margin call, and be required to fund their account.
If servicing debts eats up a lot of their financial resources (the sources of funds they’re using to pay the debt), investors and companies are considered highly leveraged. If servicing debts exceed their available financial resources, they’re considered over leveraged.
In the case of companies, how much they’re financially leveraged can be measured using a financial leverage ratio — a type of measurement used to evaluate a company’s level of debt relative to another financial metric. In the debt-to-equity (D/E) ratio, one of the most common leverage ratios, that other metric is equity. The D/E ratio is calculated by dividing a company’s total liabilities (debts) by its total shareholder equity.
Examples of financial leverage
Let’s look at how financial leverage works in practice, using a simple personal investing example involving a bank loan.
Your friend Tom is a savvy investor. He has identified what he thinks is a “guaranteed” investment opportunity, and wants you to get in on it. (Now, guarantees don’t exist in investing, but this is just an example.) He promises to return your money, plus an additional 50% after one month.
But you only have $1,000 to invest. So, you borrow an additional $4,000 from your bank. They want $120/month in interest. You give $5,000 to Tom and he returns $7,500 a month later (turns out it was a good opportunity). You pay the bank its $4,120 (the loan plus one month’s interest) and pocket the remaining $3,380.
In this example, you leveraged your $1,000 to buy more of Tom’s opportunity than you could have afforded on your own. If you invested your own cash, you would’ve only earned $500. By borrowing money from a lender, you earned $2,380.
That’s an example of how financial leverage can be used to increase your returns. But what if Tom was wrong, and the investment opportunity wasn’t so great?
After one month, your $5,000 investment is gone. You need to pay the bank $4,120 (the money you borrowed, plus one month’s interest). Plus, you lost your own $1,000.
That scenario highlights the risk of leverage. If investments fail, you can be left dealing with substantial losses.
Advantages and disadvantages of financial leverage
Before you start borrowing money to buy stocks or invest in ETFs (or anything else), it’s important to understand the pros and cons of financial leverage.
Pros of financial leverage
Increased buying power. Financial leverage is a powerful tool because it allows you to invest more than they could with just your own cash.
Access to opportunities. With that increased buying power comes access to investing opportunities that may have otherwise been out of reach.
Higher returns. Financial leverage can amplify your gains if your investment performs well. It multiplies the value of every dollar of your own money you invest.
Cons of financial leverage
Amplified losses. For the same reason financial leverage can boost returns on your investments, it can also amplify your losses. If the value of an investment fails to rise above the cost to borrow the money, or if the value of an asset falls, then your investment costs you money.
Interest costs. Interest payments on the money you borrow eat into your returns. If your investment doesn’t perform well, they add to your losses.
Limited flexibility. Using financial leverage increases your debt levels, which can restrict your ability to make new investments, qualify for financing for big purchases (such as a car or a house), and handle unexpected expenses.
Final thoughts on financial leverage
Borrowing to invest is inherently risky, simply because it can amplify your losses and leave you saddled with debt obligations. Before you consider using financial leverage in your portfolio, you need to feel confident in the investments you’re making and your ability to handle any resulting losses.
