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. 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
When business owners need to buy something that they don’t have the cash to pay for upfront, they can use either debt or equity to finance that purchase. 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. 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
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
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.
Combined Leverage
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.
