leverage

The amount in which a purchase is paid for in borrowed money. The greater the leverage, the greater the possible gain or potential loss.

Leverage

1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage helps both the investor and the firm to invest or operate. It, however, comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater amount than it would've been if the investment were not leveraged - leverage magnifies not only gains but also losses. In the business world, a company can use leverage to generate shareholder wealth, but if it is fails to do so, the interest expense and credit risk of default destroys shareholder value.

Investopedia Commentary


1. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in, say, five options contracts. You would then control 500 shares rather than 10.

2. Most companies use debt to finance operations. By doing so a company increases its leverage because it can invest in business operations without increasing its equity. For example if a company formed with an investment of $5 million from investors, the equity in the company is $5 million and this is the money it uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations, and more opportunity to increase value for shareholders.

Related Links

When Companies Borrow Money
Debt Reckoning
Margin Trading Tutorial

See also: Deleverage, Derivative, Futures, Leveraged Buyout, Margin, Operating Leverage, Options, Risk/Return Tradeoff

leverage

The use of fixed costs in order to increase the rate of return from an investment. One example of leverage is buying securities on margin. While leverage can operate to increase rates of return, it also increases the amount of risk inherent in an investment. See also financial leverage, operating leverage.