Leverage is another way to refer to debt. In business, leverage often refers to borrowing funds to finance the purchase of inventory, equipment, or other assets. Businesses use leverage instead of using equity to finance those purchases.
Review a complete explanation of what leverage is, how it impacts investors, and the kinds of leverage you may hear analysts refer to.
What Is Leverage?
When someone goes into debt to acquire something, this is also known as "using leverage." The term "leverage" is used in this context most often in business and investing circles.
Borrowing funds in order to expand or invest is referred to as "leverage" because the goal is to use the loan to generate more value than would otherwise be possible.
While less common, leverage can also refer to the use of something to achieve more than you would have been able to without it. For instance, businesses can leverage debt, but they can also leverage their assets, their social presence, their fanbase, or their political connections.
How Leverage Works
If they choose debt, then they're using leverage to finance the purchase. In many ways, this leverage works like any other form of debt. The business borrows money with the promise to pay it back, just like a credit card or personal loan. Debt increases the company's risk of bankruptcy, but if the leverage is used correctly, it can also increase the company's profits and returns—specifically its return on equity.
Using equity financing instead of leverage would mean offering partial ownership in the company in exchange for help purchasing something. For a public company, this would mean a new offering of shares.
With debt financing, the interest payments are tax-deductible, regardless of whether the interest charges are from a loan or a line of credit. In addition, by making timely payments, a company will establish a positive payment history and business credit rating.
Investors usually prefer the business to use debt financing, but only to a certain point. Investors get nervous about too much debt financing, as it drives up the company's default risk.
Types of Leverage
The concept of leverage is used in breakeven analysis and in the development of the capital structure of a business firm. Generally speaking, there are three types of leverage in this context:
Financial leverage follows the straightforward definition of leveraged discussed so far. It refers to the amount of debt in the accounts of the firm.
The use of financial leverage in bankrolling a firm's operations can improve the returns to shareholders without diluting the firm's ownership through equity financing. Too much financial leverage, however, can lead to the risk of default and bankruptcy.
One of the financial ratios used in determining the amount of financial leverage a business has is the debt/equity ratio, which shows the proportion of debt a firm has compared to the equity of its shareholders.
Operating leverage applies the concept of leverage to the cost of providing goods and services. It stems from the breakeven analysis technique, which identifies two types of costs in a company's structure: fixed costs and variable costs. Operating leverage is the ratio of fixed costs to variable costs.
If a business firm has more fixed costs as compared to variable costs, then the firm is said to have high operating leverage. These may also be referred to as capital-intensive firms. An example is an automotive company like Ford, which needs a huge amount of equipment to manufacture and service its products. When the economy slows down and fewer people are buying new cars, Ford still has to pay its fixed costs, such as overhead on factories and depreciation on equipment that sits in the warehouse.
This is thought of in terms of leverage because, while the equipment may be listed as an asset on the balance sheet, there are fixed costs associated with acquiring and maintaining that equipment. These costs are paid in the hopes that the assets acquired can be leveraged to turn a profit.
The opposite of a capital-intensive firm is a labor-intensive firm. Labor-intensive companies have fewer fixed costs but require greater human capital for the production process. Service businesses, such as restaurants and hotels, are labor-intensive. In difficult economic times, labor-intensive firms typically have an easier time surviving than capital-intensive firms.
A capital-intensive firm with high operating leverage is sensitive to sales. A small change in sales volume disproportionally hits the company's bottom line and ultimately results in a large change in return on invested capital.
As the name implies, combined leverage, or total leverage, is the cumulative amount of risk facing a firm. This combines operating leverage, which measures fixed costs and assets, with the debt financing measured by financial leverage. Combined leverage attempts to account for all business risks, and it's the total amount of leverage that shareholders can use to borrow on behalf of the company.
- Leverage refers to debt that an entity uses to achieve greater returns.
- Though less common, leverage can be used in any context in which something is used to achieve greater returns than would have been possible without it.
- Using leverage is as opposed to using equity, which would avoid debt but dilute the ownership among existing shareholders.
- Accountants and analysis may further break down leverage into three categories: financial leverage, operating leverage, and combined leverage.