Leverage

Definition

Leverage refers to the use of borrowed funds or financial instruments to increase the potential return on an investment. It allows businesses to amplify their financial resources and undertake projects or investments that may not be possible with their own capital alone.

5 Must Know Facts For Your Next Test

1. Leverage can be used to increase the potential returns on an investment, but it also carries the risk of greater losses if the investment underperforms.
2. Businesses can use leverage to finance growth, expand operations, or undertake new projects that may not be possible with their own capital alone.
3. The degree of leverage used by a business is often measured by the debt-to-equity ratio, which compares the amount of debt to the amount of equity in the company's capital structure.
4. Excessive leverage can increase a business's financial risk and make it more vulnerable to economic downturns or unexpected events.
5. Prudent use of leverage, combined with sound risk management practices, can be an effective way for businesses to enhance their financial capabilities and competitiveness.

Review Questions

• Explain how businesses can use leverage to finance their operations and investments.
  • Businesses can use leverage to finance their operations and investments by borrowing funds, such as through loans or the issuance of bonds. This allows them to access additional capital beyond what they have available from their own equity, enabling them to undertake larger projects or make investments that may not be possible with their own resources alone. The use of leverage can amplify the potential returns on these investments, but it also carries the risk of greater losses if the investments underperform.
• Describe the relationship between leverage and a business's capital structure.
  • The degree of leverage used by a business is often measured by the debt-to-equity ratio, which compares the amount of debt to the amount of equity in the company's capital structure. A higher debt-to-equity ratio indicates a greater reliance on leverage, as the business is using more borrowed funds relative to its own equity. The capital structure of a business, and the balance between debt and equity, can have significant implications for its financial risk, cost of capital, and overall competitiveness.
• Analyze the potential risks and benefits associated with the use of leverage by businesses.
  • The use of leverage can provide businesses with the opportunity to amplify their financial resources and undertake larger or more ambitious projects, potentially leading to higher returns. However, excessive leverage also carries significant risks, as it can make a business more vulnerable to economic downturns or unexpected events. If an investment or project financed with borrowed funds underperforms, the business may face greater financial losses due to the amplifying effect of leverage. Businesses must carefully weigh the potential benefits of leverage against the increased financial risk and develop prudent risk management strategies to ensure the responsible and effective use of borrowed funds.

Related terms

Debt Financing: The use of borrowed money, such as loans or bonds, to fund a business's operations or investments.

Equity Financing: The process of raising capital by selling ownership stakes in a company, such as through the issuance of stocks.

Financial Leverage: The use of debt to increase the potential return on equity investments, but also the potential for greater losses.