Leverage results from using borrowed capital as a funding source when investing to expand the firm’s asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment.
Leverage can also refer to the amount of debt a firm uses to finance assets. When a company, property, or investment is referred to as “highly leveraged”, that means the item has more debt than the equity.
Leverage can be used to help finance anything from a home purchase to stock market speculation. Businesses widely use leverage to fund their growth, families apply leverage—in the form of mortgage debt—to purchase homes, and financial professionals use leverage to boost their investing strategies.
Both investors and enterprises use the leverage concept. Investors use leverage to increase the returns that investment can provide significantly. They maximise their investments through the use of different instruments, including options, futures, and margin accounts.
The companies can use leverage to fund their properties. In other words, companies can use debt financing to invest in business operations in an attempt to increase shareholder value instead of issuing stocks to raise capital.
Investors that are uncomfortable to actively use leverage have several ways to control leverages indirectly. In the normal course of their business, they can invest in companies that use leverage to finance or expand operations without increasing their outlay.
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.