"Give me a lever long enough, and a prop strong enough, and I can singlehandedly move the world."
The idea of mechanical advantage in physics can to a certain point be extended (pun intended) into other frameworks of understanding, including the idea of leverage as it pertains to finance. Not to be overly simplistic in reasoning, but the simple fact is this: leverage is force. It is the power which can be exerted upon something because one is in a superior position. In the case of business, leverage exists because it implies dependence - through borrowing of funds, through deliberately indebting itself to another entity, a firm is allowed to greatly extend its power.
- "Leverage" is the capacity that a lever has to move something.
- "Leveraging" is the process of using that tool, applying a small force to obtain access to a greater force.
Financial leverage is the volatility of operating income caused by fixed interest payments on borrowed money. It is a type of financial risk and uncertainty which a firm's indebtedness causes.
Financial leverage is somewhat open-ended in magnitude. A business can profit greatly because of leverage, a great deal beyond its capabilities with owned assets; however, it's equally possible that the firm will lose far more than it would have without having leveraged itself. In a sense, to properly understand leverage and its possibilities is to make debt - deliberate and calculated dependence on another entity - into a financial tool. Employing that tool implies risk.
Risks of Leveraging : The Debtor
In effect, leverage occurs with debt/financing because when you borrow money, you are paying for the privilege of treating someone else's money as if it were your own. So long as the payments can be met, the amount borrowed is essentially "free" - it is not an expenditure from your personal finances, nor can it be considered income. Thus a small investment can potentially control a very large sum, as it is only the payment on principal and interest which must appear on a cash flow, that must be met with cash to secure the principal.
Moreover, if you are able to borrow, paying only interest, with the principal due by a certain time in the future, you have effectively gained the principal for the cost of the interest! Ceteris paribus, if it's possible to make a profit beyond what was borrowed, you can pay off the debt and actually gain from having incurred it. This is a prime example of the reason for the existence of the Risk-return relationship. It can also be a very blatant demonstration that the idea of creating wealth is not just clever marketing jargon.
It's important to note that the mere act of borrowing money is not leverage per se, it is simply a technique which can be used to achieve it. Of course, because borrowing incurs the risk of default, achieving leverage in this way also incurs risk proportionally.
Leverage vs. Consumer Debt
Consumer debt is only leverage in a very limited sense. The business enters into debt because it attempts to achieve a higher profitability than was possible without the borrowed money. Thus if they achieve that goal, and can profit beyond their payment on interest and principal, they have actually profited from their incursion of debt. The consumer, on the other hand, willfully enters into debt to achieve a lifestyle which his ordinary income could not afford him.
Debt in this sense is purely a delayed expenditure with no profit-earning potential and no value beyond personal pleasure and the ability to present an image of a richer lifestyle - a lifestyle which, of course, can only be fully achieved through incurring more debt, financing debt with debt, or raising your income.
Risks of Leveraging : The Investor
The entity which is investing or lending is also taking on a substantial risk in doing so. There are a few simple financial ratios which can be used to make a rough judgment of the firm's ability to at least cover its long-term debt obligations.
One of the measures which indicates the degree of risk to an investor is the debt to equity ratio,
( Long-term Debt / Common Stockholders' Equity )
The ratio gives a basic idea of the risk of shareholder equity, and of the ability of the firm to pay dividends or retain earnings.
The second measure is the debt to total assets ratio:
( Long-term Debt / Total Assets of the Firm )
This tells us what percentage of the firm's assets are financed with debt. It's vital to us as potential investors to understand how much of the claimed assets a firm actually owns.
These ratios are obviously useful in the financial analysis of a company, because they give an idea of the extent to which the firm actually owns its own resources, and thus of its ability to liquidate them to pay its debts if it became necessary to do so. This is quite important to you as an investor, because it provides a broad assessment of your financial risk in the event of insolvency.
In summary, financial leverage might best be thought of as understanding debt as a tool rather than a condition.
(node what you learn