Leverage in finance refers to the strategy of using borrowed money to invest with the goal of increasing the potential return of an investment. It can refer to a variety of financial arrangements, including corporate and individual borrowing, the use of derivatives, and investing with equity.
There are three main forms of financial leverage:
- Operating Leverage: This refers to a company’s fixed costs of production. The more fixed costs a company has, the more of its income that goes towards covering these fixed costs, and the more sensitive its net income is to changes in sales. A company with high operating leverage will see a larger increase in profits from a small increase in sales than a company with low operating leverage.
- Financial Leverage: This refers to the use of debt to finance an investment. If a company or individual borrows money to invest and the investment returns more than the cost of the borrowing, then they will have made a profit. However, if the investment returns less than the cost of borrowing, they will be left with a loss.
- Combined Leverage: This takes into account both operating and financial leverage. It reflects the total risk of the firm.
While leverage can amplify potential profits, it also increases potential losses and financial risk. If an investment financed with leverage goes poorly, the investor could end up losing more money than they initially invested. For this reason, leveraging should be used wisely and with a good understanding of the risks involved.