It is a term that you may well be familiar with but understanding the mechanics of financial leverage and how to use it to your advantage takes a greater level of comprehension if you are going to maximize your opportunities.
Here is an overview of what financial leverage is all about and when it is deployed as a tactic that will resolve or improve a monetary situation.
In simple terms, financial leverage is the term used to describe how you can use debt to your advantage and borrow money on the basis that you expect to make a greater return from the proposed investment or project.
If you are confident that you could turn a profit on a deal, you might use leverage as a way of funding the opportunity, knowing that there is a good chance you will be able to repay the cost of borrowing and still come away with a profit.
Certain investors often use leverage as a tool for amplifying their purchasing power and to be able to take advantage, and companies frequently consider using leverage as a viable alternative to issuing stock to raise capital, raising finance via their assets with the view that taking on debt in such a scenario allows them to invest and increase shareholder value in the process.
Understanding the risks
As you might expect, borrowing money in this way does not come without its risks and there are a number of potential disadvantages attached to using leverage that need to be considered and evaluated when analyzing a potential deal.
The bottom line is that leverage also has the potential to increase losses.
If your judgment call is wrong on the deal, and the investment opportunity does not go according to plan, the fact that you have loaded up with debt to finance the deal, will mean that you are facing increased losses because you have increased your financial exposure by using leverage.
If everything goes to plan, a company or investor can use leverage as a way of generating wealth with borrowed money, but there is always the potential to damage shareholder value if a business deal fails to deliver on its initial promise.
Leverage in action
To understand the potential of leverage, take a scenario where a company raises $2 million from investors and then uses debt financing to borrow another $8 million.
This means it has increased its buying power via debt financing and it can invest in opportunities that it believes will deliver greater shareholder returns, such as using the money to buy production facilities, for instance.
If the new facility increases production, it could justify the investment by delivering greater sales and profitability, meaning that leverage has allowed the business to improve its financial performance by using debt in this way.
Leveraging is a complex financial instrument and tends to be used by those who have already cut their teeth in the world of finance, meaning they understand the pros and cons attached to what financial leverage has to offer.