What is financial leverage
Financial leverage is one of the strategy in investment of using debt instruments and borrowed capital in increasing the rate at which the investment returns go higher. This is the total amount of debts used to increase the company assets through investments. When a company is highly leveraged, it simply means the company has high debt in financing the company than the equity it is using.
A leveraged company makes use of either debt to finance it alone or uses both the equity and the debt financing. Most people refers to leverage as margin but they are two different things even though both deals with the act of borrowing but leverage has to do with debt financing while margin has the money borrowed for the purpose of using it to invest in other financial tools or instruments. In margin, the money borrowed are used in purchasing of securities at a fixed interest rate for the purpose of receiving a high return.
Leverage in finance Break down
I will try and break down the meaning financial leverage as simple as possible to be well understood. In leverage, there is something like having debt and equity. In a way that the debt in using to finance a particular property or company is higher than the equity. The equity is your asset while the debt is your liability. For example, you need to buy house from an estate agent at the amount of $35,000 but you only have $3,500 at hand and had to borrow money from bank to balance the payment up. The money borrowed which is $31,500 is the debt and the $3,500 which is yours is the equity. The equity percentage is 10% while the borrowed money is 90%. The money the buyer had borrowed has made him to be able to purchase the more expensive house than the one he would have bought with the available money with him.
The buyer in this case is said to be levered ten to one. This mean that for every $10 spent from the borrowed money for the vehicle, the buyer personal money is $1. To get this even better, the buyer sold the house bought from the agent at the amount of $38,500 to another buyer. In the calculation, it shows that the buyer has had $3,500 profit which makes it to be 100% ignoring the interest rate on the money borrowed. This 100% is the return of the investment from which the buyer has invested. The house is the investment while the $3,500 after selling the house is the return.
If we should consider that the buyer should have bought the house with his own money, he would have gained 10% in way that if he really provided $35,000 for the house and have to sell it for $38,500, he would still have gained $3,500 which is 10% but he had provided $3,500 and still have $3,500 profit which is 100%. If the two scenario have to be compared, he actually made the same amount of profit but know that he did not make the same rate of profit.
Financial leverage example
Another place financial leverage can be used is in stocks market. For example, a company sells out stock to finance the affair of the company by investing. He had gained $6m from the stock sold but the investment of the company is $30m. He borrowed $24m from finance company to add up to the $6m in the company account.
Now the company used the money in investing and at the end of the year, the company has made $60m, from the investment. If the capital is to be subtracted, the company is left with $30,000 which is mathematically 100% profit. But the company is also owning the finance company $24m, at that stage the financing of the company with personal money is $6m which is 10% of the capital used, therefore the company is levered with 10 to 1.
If the interest is to be ignored from the profit made by the company from the investment, the company has made a profit of $30,000 which is 500%. The company has made times 500 of the money they used in investing. The financial leverage has more profit from the investment though the debt used in the investment is more than the equity. This takes us to the definition of leverage. Leverage is the debt which is usually higher than equity used in increasing the assets of the company.