Financial Leverage
Financial Leverage refers to the use of borrowed funds to increase the potential return on investment. It involves using various financial instruments or borrowed Capital—such as debt—to amplify the outcomes of an investment. The underlying principle is that by using leverage, investors can increase their exposure to a particular Asset or project, potentially increasing both the risks and rewards.
When a company takes on debt to finance its operations or investments, it is said to be leveraging its Capital. The more debt a company has relative to its Equity, the higher its financial leverage.
Examples:
- A real estate investor purchases a property for $500,000, financing $400,000 with a mortgage and Investing $100,000 of their own Capital. If the property appreciates to $600,000, the investor can sell it for a profit. The leverage amplifies the return on their initial investment.
- A Corporation issues Bonds to raise $1 million for expansion while having $500,000 in Equity. If the expansion generates Returns greater than the Cost of Debt, the company’s return on Equity improves significantly.
Cases:
- During the 2008 financial crisis, many Financial Institutions used excessive leverage. When Asset values fell, they faced significant losses, leading to bankruptcies and bailouts.
- In contrast, companies like Apple have effectively used financial leverage to invest in growth without sacrificing their balance sheets, maintaining a healthy ratio of debt to Equity.