What is Leverage?

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Definition:

Leverage is a strategy wherein a person or business uses borrowed money to buy an asset — this may increase their potential gains, but it also comes with the risk of amplifying their losses.

🤔 Understanding leverage

Leverage is an investment strategy of using borrowed capital to increase the potential return on an investment. Leverage can also refer to the amount of debt used to finance an asset. If you have an investment plan and believe strongly in it, you might want to invest as much money as you possibly can in that plan. Leverage is the strategy of borrowing additional money that you use to invest. People can use leverage to amplify potential gains and potential losses from an investment plan. Businesses can use leverage to fund expansion or additional projects they wish to undertake.

Example

If you have $5,000 to invest and decide that you want to use it to purchase shares of a stock that costs $100 per share, you can buy a maximum of 50 shares. To use leverage, you might borrow an additional $5,000, which would let you buy up to 100 shares of the company that you would like to invest in. You’ve leveraged your investment with a 2:1 leverage ratio. Your potential profit is much larger in this scenario — and so is your potential loss.

Takeaway

Leverage is like borrowing money to buy a house…

If you don’t have enough savings to pay for the house, you need to get a mortgage from a bank so you can afford the purchase. When you borrow money from the lender, you have to pay it back, plus interest. Later, if you move and have to sell your home, you need to pay back the mortgage. If you sell the house for less than you paid, you can wind up losing money on the deal.

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What is leverage, and why is it important?

A person or business uses leverage when they borrow money that they later use to invest. For an individual, they can use leverage to buy a home, a car, or invest in the stock market. Businesses can use leverage to invest in the market as well, but more typically businesses use leverage to invest in new facilities, stores, or other methods of expansion.

Leverage is powerful because it gives people and businesses a way to augment their cash reserves, which amplifies the effect of their investments. Companies that use leverage can grow more quickly than they would have otherwise, assuming their investments turn out well. Similarly, individual investors can earn higher returns by using leverage.

On the other hand, if a leveraged investment performs poorly, the losses are amplified, which means businesses can fail more quickly — or investors can lose more money, including more than their initial investment

How does leverage work?

Leverage works by amplifying the effect of an investment. Consider this example:

You’re about to bet $100 on the result of a coin flip. If it comes up heads, you’ll double your money. If it comes up tails, you’ll get nothing. In the best case, you’ll make $100. At worst, you lose $100.

If you use leverage to borrow another $100, you can bet $200 on the coin flip. Now, you can make or lose twice as much based on the result of the coin flip. You’ve leveraged your bet 2:1. As long as you can find people willing to lend you money, you can keep leveraging your bet to amplify the results of a win or loss even further.

If you borrow $4,900, you can bet $5,000 on the coin flip, even though you only have $100 of your own money, walking away with $10,000 or $0 (and owing $4,900) depending on the results of the coin flip.

This example illustrates the risks and rewards of leverage. It would take dozens of coin flips for you to have a chance of walking away with $10,000 if you start with $100 and keep on winning and winning. Using leverage lets you reach that number far more quickly. On the other hand, if you lose the flip, you’ll have no money and have to come up with a way to pay your new debt.

In all of these scenarios, you have to pay back the money that you borrow, plus any interest, so your actual gains will be less than the full amount you receive from winning the coin flip. If you borrowed $4,900 so you could bet $5,000 and win $10,000, you’ll have to pay the $4,900 back, leaving you with $5,100 in the end. If you lose the coin flip, you’re out your original investment of $100, and still have to pay the loan back, leaving you at a balance of -$4,900.

In the context of business, leverage can help a company expand more quickly. If it costs $100,000 to open a new retail location, a business can borrow $500,000 to open five additional locations. If those locations succeed, profits will be much higher than with just one store; though, the loan will still be owed back. If those locations flop, the business will lose money on the new locations — and it will owe back the borrowed money.

What are the types of leverage?

For businesses, there are two types of leverage: financial leverage and operating leverage. Financial leverage is borrowed money that the company uses for investment.

Operating leverage is an accounting formula for how a company’s operating expenses relate to its revenue. A company with higher fixed expenses will see more impact from a rise in revenue compared to a company with more variable expenses. Similarly, companies with higher fixed costs will lose more than a company with variable costs when profits go down.

Businesses with high operating leverage need to understand the risk of such leverage. To reduce the impact of poor performance, businesses with high operating leverage need effective forecasting tools to predict future customer demand. If the company can use its forecasts to reduce the fixed costs of production (for example, letting the lease on a production facility expire instead of renewing it), it can reduce its potential losses from low customer demand.

Is financial leverage good or bad? What are the pros and cons?

Financial leverage isn’t inherently good or bad. It is a tool that is available to businesses and investors that can be used well or poorly. Financial leverage amplifies the results of investment, so businesses and individuals that invest well will benefit from it. Those that invest poorly must deal with the negative effects. Investment returns can never be guaranteed. All investments carry risk.

The pros of financial leverage include:

  • Amplified gains from successful investments.
  • Small businesses can access the capital needed to grow.
  • Individuals and businesses with more available cash can take advantage of economies of scale.

The cons of financial leverage include:

  • Amplified losses from unsuccessful investments.
  • Individuals and businesses must pay interest on borrowed money.
  • Leverage allows people and businesses to lose more money than they have, potentially bankrupting them.
  • Taking on debt reduces access to additional debt until the original debt is paid.
  • In trading, if an investment performs poorly, the lender may make a margin call, forcing the investor to sell enough securities to repay their debt or deposit additional collateral.

What are the differences between leverage and margin?

Margin is money that an investor borrows for the explicit purpose of investing in securities. Leverage refers to taking on debt in general. Margin is a type of leverage that gives individual or institutional investors access to extra cash for investment purposes.

Investors need a margin account to invest using margin. Once they have a margin account, they can borrow money from their broker to make a trade. For example, an investor who wants to buy $10,000 worth of shares in company ABC may only have to provide $5,000 of her own money. The broker lends the other $5,000. In this scenario, the investor's initial margin requirement is 50%. They had to provide at least 50% of the cost of an investment.

Margin requirements can vary and are often based on the investor's balance. Financial Industry Regulatory Authority (FINRA) requirements state that investors must have at least $2,000 in their account to be eligible for margin trading.

When borrowing money to invest, the investor is said to be buying on margin. As long as the investor’s position remains open, they have to pay any costs associated with the margin, such as interest. FINRA regulations also require that investors maintain at least 25% equity in a margin account in most circumstances. Some brokers have higher requirements, and requirements may vary by security. If an investor’s equity falls below that amount, they’ll have to deposit more cash or securities, or allow the broker to sell your investments for a loss.

How do you calculate leverage?

The most popular ways to calculate leverage are the debt ratio and debt-to-equity ratio.

The formula for the debt ratio is:

Debt Ratio = Total Debt / Total Assets

This ratio shows how much a company has borrowed compared to the total value of its assets. A ratio of 1 or less indicates that the company could pay its debts by liquidating its assets. Ratios higher than 1 show that the company owes more than it could pay by liquidating assets.

The formula for the debt-to-equity ratio is:

Debt-to-Equity Ratio = Total Liabilities / Shareholder Equity

The debt-to-equity ratio shows a company’s total debt as compared to the value of the company.

The formula for calculating operating leverage is:

Operating leverage = Contributing Margin / Profit

Where

Contributing Margin = (units sold x (price - variable cost per unit)) / (units sold x (price - variable cost per unit) - Fixed Operating Costs)

Regardless of the underlying value of the securities you purchased, you must repay your margin loan. Robinhood Financial can change their maintenance margin requirements at any time without prior notice.

If the equity in your account falls below the minimum maintenance requirements (varies according to the security), you’ll have to deposit additional cash or acceptable collateral.

If you fail to meet your minimums, Robinhood Financial may be forced to sell some or all of your securities, with or without your prior approval. For more information please see Robinhood Financial’s Margin Disclosure Statement, Margin Agreement and FINRA Investor Information.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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