What is meant by leverage?
Leverage or financial leverage – also known as the leverage effect – is basically an investment in which borrowed money or debt is used to maximize the return on the capital invested. The borrowed money can be used to acquire additional assets or raise funds for the company to increase profits. Investors or companies take on debt by borrowing money or capital from lenders and promising to repay this debt with the additional interest. The leverage effect occurs when the return on the borrowed money is higher than the interest that has to be paid on the money. In leveraged investment strategies, borrowed money is used to increase the potential return on an investment. There are, for example, a large number of leveraged financial products that promise just as high returns, but also involve a higher risk.
A company can use leverage for various reasons, for example to acquire new assets or to optimize the capital structure and ultimately the average cost of capital for tax purposes with the so-called tax shield. This in turn allows higher income to be generated with a relatively smaller amount of equity, which ultimately leads to a higher return on equity.
A private investor can also use leverage to increase the return on their investments. They leverage their investments either by using various instruments such as options, futures and margin accounts or by simply taking out a Lombard loan. Put simply, a Lombard loan is similar to a mortgage in one respect – both types of loan involve the provision of collateral. In the case of a mortgage, it is a property. With a Lombard loan, it is a securities portfolio.
Investors who are not directly interested in leverage can use leverage indirectly. This is possible, for example, by investing in companies that use leverage in their business activities. Alternatively, you can invest in an ETF that uses leverage. To better understand leverage, some information is needed: The most important factors are the value of the asset and the interest on the loan that the company has taken out. If the value of an asset increases and exceeds the interest on the loan, the investor or the company that owns the asset receives a higher return and therefore makes a profit. If, on the other hand, the value of the asset falls, the investor or the company that owns the asset suffers a loss.
Given this logic, the company must generate more return than it has to pay in interestin order to maximize profits. Companies usually plan to achieve this by using a combination of equity and debt to finance their operations or raise funds. Therefore, if you are investing as an investor or running a business as a company, you need to fully understand leverage as it plays an important role in running the business. You must be willing to borrow and invest to maintain the profit margins of your company and business. If leverage is to be used, it may be beneficial to utilize the knowledge of an experienced asset manager.
The balance sheet analysis to determine leverage
Using a balance sheet analysis, investors can examine the debt and equity on the books of various companies and invest in companies that finance their businesses with debt. Ratios such as return on equity (ROE), debt-to-equity ratio and return on capital employed (ROCE) help investors determine how companies are using their capital and how much of that capital is borrowed. In order to interpret these ratios correctly, it is important to know that there are different types of leverage, including operating, financial and combined leverage.
The degree of operating leverage is used in fundamental analysis. The degree of operating leverage is calculated by dividing the percentage change in a company’s earnings per share (EPS) by the percentage change in earnings before interest and taxes (EBIT) in a given period. The degree of operating leverage can also be calculated by dividing a company’s EBIT by EBIT less interest expenses. A higher operating leverage ratio indicates a higher degree of volatility in a company’s earnings per share (EPS).
The equity multiplier is another indicator for measuring financial leverage: to calculate it, a company’s total assets are divided by its total equity. For example, if a company has total assets of CHF 1,000,000 and equity of CHF 500,000, the division results in a value of 2. This is the equity multiplier. It shows that the total assets are twice as high as the equity – or vice versa, that half of its total assets are financed by equity. Higher equity multipliers therefore indicate a higher level of financial debt.
Leverage vs. margin
While margin refers to the amount of money required to open a position and is dependent on the margin required, leverage is the calculation of the leverage used to achieve higher returns and account for shares for your business or company.
Margin can also be seen as a special form of leverage, where existing cash or securities positions are used as collateralto increase the purchasing power of the company. Margin thus makes it possible to borrow money from a lender at a fixed interest rate to buy positions, securities and futures contracts in order to maximize profits. This means that while margin and leverage are not exactly the same thing, margin can be used to create leverage to increase your buying power by a small amount.
This allows you to leverage with margin by increasing your purchasing power by the amount of the margin. For example, if collateral of CHF 100 is required to buy CHF 1000 worth of securities, you would have a margin of 1:10 (and 10x leverage).
Examples of leverage
Example 1 – Company
Assume that company X was founded with an investment of CHF 2 million from investors, with the company’s equity amounting to CHF 1 million. Assume the company also takes on debt financing of CHF 2 million and therefore has CHF 3 million (1 million equity plus 2 million debt) to invest in its business operations. This gives Company X more opportunities to increase value for shareholders. For example, the company could invest in a new production facility and thus produce more, thereby increasing profits. The advantage exists if the additional profit is higher than the costs (interest) for the borrowed capital.
Example 2 – Private investor
Suppose an investor has CHF 5000 that he wants to invest in shares. Let’s assume that the share generates a profit of CHF 500, i.e. a return of 10%. The return on equity is calculated by dividing the profit by the equity and multiplying by 100. Assume that the investor now also invests debt capital. The investor therefore invests his CHF 5000 equity and borrows an additional CHF 5000 from the bank (debt capital), which he also invests. The investor has to pay 5% interest on the borrowed capital. Initially, the profit doubles, as twice as much has been invested. The return is therefore CHF 1000, but the profit is reduced by the interest that the investor has to pay back to the bank. The investor therefore pays the bank CHF 250, but as the profit on the money invested (CHF 500) is higher than the interest (CHF 250) in this case, the investor makes an additional profit by using the borrowed capital. The interest (5%) is therefore lower than the return (10%). However, the leverage effect can have a negative impact if less is earned in returns than has to be paid in interest.
Advantages and disadvantages of leverage
Like any other financial product, leverage has its pros and cons. Because leverage is a multi-layered financial product, it is inherently complex and can increase both profits and losses when used by a company or an individual investor. The theory sounds great, and in reality the use of leverage can be profitable, but the opposite is also possible, as leverage increases both profits and losses. For this reason, the use of leverage should only be implemented by experienced investors or with the help of a good investment advisor.
The following advantages and disadvantages can be summarized:
Advantages
Companies or sole proprietorships that borrow through leverage investments can make a small investment. Through this leveraged investment, these companies and businesses can acquire more assets and funds for their organization. Suppose the value of the assets increases and the terms are favorable. In this case, borrowers have a great advantage as they can earn higher returns on their investments, which helps them stay within the profit margin.
Disadvantages
The risk involved in using debt capital is the loss that companies can suffer if the value of the assets falls and is lower than the interest that the companies have to pay on their debt. This financial risk is particularly high in certain industries such as construction, oil production and car manufacturing, as these companies can suffer very large losses if the value of their assets falls.
If not used correctly, the leverage effect of investments can prove fatal for companies and even cause them to go out of business. This is especially true for companies with less predictable revenues and lower profitability. This is also the reason why many first-time investors are advised not to use leverage until they have gained enough experience to avoid a large loss.
Leverage is therefore a double-edged sword: ABB was a prominent example of this. ABB had taken the optimization of its capital structure to such an extreme that rumours of liquidity bottleneckspersisted around 2002. Equity was very low and debt was very high – it accounted for over 70% of total capital. As a result, ABB found it difficult to raise long-term debt and had to pay high interest rates on it. ABB managed to turn the tide by drastically reducing its debt and increasing the proportion of debt with longer maturities. However, if ABB had not restructured its debt in time, this could have resulted in insolvency.
Private investors should also be careful with leverage: namely when, for example, the ratio between a loan and the value of the collateral deposited becomes too high. This can lead to the borrower being forced to deposit more collateral, to repay part of the loan or to the ownership of the asset – which was deposited as collateral – being transferred to the lender. This means that you can also lose the deposited collateral. Leverage has already led to borrowers having more debt than their total assets and being unable to repay them. However, these are extreme examples and also a sign that the lenders did not have their risks under control and had issued excessive loans to individual borrowers.
It is extremely important to keep the above-mentioned advantages and disadvantages in mind and to weigh up all possible risks before making a leveraged investment as a company or as an individual investor.