What is Leverage?

Leverage is the use of debt to finance an organization’s activities and asset purchases. When debt is the primary form of financing, a business is considered to be highly leveraged. Leverage is used to increase the return on equity for investors. In essence, using debt instead of equity can boost the return that investors are experiencing.

Example of Leverage

As an example of leverage, if investors buy $1 million of stock and the business then earns $100,000 of profits, their return on investment will be 10%. If they had instead invested $200,000 and the business had borrowed $800,000 to still achieve total financing of $1 million, the return on investment would now be 50% (though the after-tax cost of debt must also be considered).

Disadvantages of Leverage

There are several problems associated with using leverage, which are as follows:

Increased risk of losses. Just as leverage magnifies gains, it also magnifies losses. If an investment declines in value, the losses will be proportionally larger than if the investment were made without leverage.
Fixed financial obligations. Borrowed funds typically come with fixed interest payments, regardless of the financial performance of the investment. These obligations must be met even during periods of poor performance. In addition, the principal amount of the loan must be repaid according to the agreed schedule, adding pressure on cash flow.
Reduced flexibility. High levels of debt may limit an organization's or individual's ability to make strategic decisions, as they may need to prioritize debt repayment over other opportunities. Further, many loan agreements include covenants that restrict certain activities, such as taking on additional debt, paying dividends, or making new investments.
Risk of interest rate increases. If the cost of borrowing rises due to interest rate hikes, it can increase the financial burden and reduce profitability.
Liquidity risks. To meet debt obligations, investors or firms may need to sell assets, sometimes at unfavorable prices, resulting in realized losses. For leveraged investments like margin trading, a decline in asset value may lead to a margin call, requiring additional funds to maintain the position.
Impact on creditworthiness. High leverage can negatively impact credit ratings, making future borrowing more expensive or difficult.
Increased stress. The pressure of meeting financial obligations can lead to stress and potentially irrational or short-term decision-making.
Ownership dilution. If the leverage involves issuing new equity or convertible debt, the potential gains from the investment may be diluted among a larger number of shareholders.

In summary, while leverage can be a powerful tool to increase returns, it must be used judiciously and managed carefully to avoid significant financial risks. Over-leveraging can quickly lead to financial instability and long-term harm.