Leverage

Definition

Leverage refers to the use of borrowed capital or debt to increase the potential return on investment. By utilizing leverage, companies can amplify their financial performance, which can lead to higher returns for shareholders, but it also increases financial risk as obligations to pay back debt must be met regardless of business performance.

5 Must Know Facts For Your Next Test

1. Leverage can magnify both gains and losses; while it allows for higher potential returns, it also increases the risk of substantial losses if the investment does not perform as expected.
2. Companies typically assess their leverage through metrics like the debt-to-equity ratio to understand their financial structure and risk exposure.
3. Using leverage strategically can improve a company's weighted average cost of capital (WACC) by reducing the overall cost of financing when debt is cheaper than equity.
4. High levels of leverage may lead to higher volatility in earnings, which can affect a company's stock price and investor confidence.
5. When assessing investments, it's essential to consider the impact of leverage on cash flow management and long-term financial sustainability.

Review Questions

• How does leverage affect a company's cost of capital and overall financial performance?
  • Leverage affects a company's cost of capital by potentially lowering the weighted average cost of capital (WACC) when debt financing is cheaper than equity. By using borrowed funds, companies can finance growth opportunities without diluting ownership. However, while leverage can enhance returns during profitable periods, it increases financial risk, making it crucial for management to balance the benefits against potential downsides.
• In what ways can high levels of leverage influence investor perception and market behavior?
  • High levels of leverage can lead to increased market volatility and investor caution. When companies are highly leveraged, investors may perceive them as riskier investments due to the potential for increased financial strain during downturns. This perception can affect stock prices negatively, as investors may demand higher returns for taking on additional risk or may choose to invest elsewhere, impacting liquidity and overall market behavior.
• Evaluate the long-term implications of using leverage on a company's financial stability and growth prospects.
  • Using leverage can significantly impact a company's long-term financial stability and growth prospects. While it allows for expansion and increased investment in growth opportunities, excessive debt can strain cash flows and lead to difficulties in meeting obligations during economic downturns. A firm must manage its leverage carefully; if leveraged appropriately, it can fuel growth and enhance shareholder value. However, over-leveraging may result in insolvency risks and limit future financing options, ultimately affecting its sustainability in the marketplace.

Related terms

Debt-to-Equity Ratio: A financial ratio that compares a company's total debt to its shareholders' equity, indicating the proportion of financing that comes from debt versus equity.

Financial Risk: The possibility of losing money on an investment or business operation due to the use of debt, which can lead to increased volatility in earnings and potential insolvency.

Operating Leverage:

The degree to which a company uses fixed costs in its operations; higher operating leverage means that a small change in sales can lead to a larger change in operating income.