What is Reverse Leverage?

Reverse leverage occurs when the proceeds from an investment are lower than the cost of funds of a business. In this situation, a business should unwind the investment and pay back the associated funds; otherwise, the firm will continue to experience negative cash flows that could eventually lead to its demise. During periods of spiking interest rates, it is especially critical to review whether reverse leverage is occurring.

Example of Reverse Leverage

David believes that he can generate an excellent return on investment by purchasing a manufacturing company. To do so, he takes on a loan that has a net after-tax cost of 8%. After one year, he finds that the actual net after-tax return on his purchase of the manufacturing company is just 3%. Since he is generating a negative return of 5% on his investment, David has experienced negative leverage.