How can leverage increase the return on an asset

All types of investments — buying stock on margin, company expansions, leveraged buyouts, and hedge funds — employ leverage. And all of these investments work on the same principles in the above examples; they all have leverage ratios and magnify the effect of gains or losses.

An especially significant leverage problem exists with intrinsically more volatile investments, such as hedge funds. When investments underperform, hedge fund managers do not incur losses. This is the reason that hedge funds are restricted to accredited investors and larger financial institutions. Leveraging existing assets to get exponentially more return can be a risk intensive process, and represents a significant aspect of financial strategy and capital structure.

Achieving leverage can enable significant competitive advantages despite the risk, however, as it can accelerate the speed of revenue acquisition exponentially.

In order to borrow substantial amounts of capital, firms must pursue a variety of financial sourcing and be able to back up their debts with valuable assets collateral. Even with a great deal of collateral, borrowing big means risking big. Interest rates ensure that the strategic discussions around expanding leverage take into account the risk and return trade offs.

In finance, the best definitions come in equation format. The standard definition of financial leverage is as follows:. In short, the ratio between debt and equity is a strong sign of leverage. As you may already know, equity is ownership of the organization and pays out fairly significant dividends. Debt is often lower cost access to capital, as debt is paid out before equity in the event of a bankruptcy thus debt is intrinsically lower risk for the investor.

The debt to equity ratio plays a role in the working average cost of capital WACC as well, as the overall interest on financing represents the break-even point that must be obtained to achieve profitability in a given venture. WACC is essentially the overall average interest an organization owes on the capital it has borrowed for leverage. That means that the weighted average cost of capital is. A word of caution: Leverage is exponentially more risky the more it is utilized.

A useful way to view leverage is the overall existing assets of an organization compared to the amount of money they owe. If you were to be leveraged at a total of 1. Arguably a reasonable amount. A mistake of this scale on both the lenders and the Lehman Brothers threatened to topple the global economy itself. Financial Leverage Firm Value Implications : This graph illustrates a theoretical firm value maximizing curve when it comes to a debt-to-equity ratio.

Taking on debt, as an individual or a company, will always bring about a heightened level of risk due to the fact that income must be used to pay back the debt even if earnings or cash flows go down.

Return on equity shows how well a company uses investment funds to generate earnings growth. Margin allows you to borrow money from a broker for a fixed interest rate to purchase securities, options, or futures contracts in the anticipation of receiving substantially high returns.

Leverage is a multi-faceted, complex tool. The theory sounds great, and in reality, the use of leverage can be profitable, but the reverse is also true. Leverage magnifies both gains and losses.

If an investor uses leverage to make an investment and the investment moves against the investor, their loss is much greater than it would've been if they have not leveraged the investment. For this reason, leverage should often be avoided by first-time investors until they get more experience under their belts.

In the business world, a company can use leverage to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroy shareholder value. An automaker, for example, could borrow money to build a new factory.

The new factory would enable the automaker to increase the number of cars it produces and increase profits. Investing Essentials. Real Estate Investing. Financial Analysis. Fundamental Analysis. Tools for Fundamental Analysis. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Financial Ratios Guide to Financial Ratios. What Is Leverage? Key Takeaways Leverage refers to the use of debt borrowed funds to amplify returns from an investment or project.

Investors use leverage to multiply their buying power in the market.