Leverage

Financial leverage is the use of borrowed funds to increase the potential return on an investment or project. By taking on debt instead of issuing equity, companies and investors can amplify gains—but they also amplify losses and financial risk.

Key takeaways

• Leverage uses debt or borrowed capital to magnify returns.
• Common leverage measures include debt-to-assets and debt-to-equity.
• Higher leverage increases financial risk and earnings volatility.
• Leverage can be appropriate for growth or short-term, well-timed opportunities but requires careful risk management.

How leverage works

Leverage lets an entity invest more than its equity base by using borrowed money. Both companies and investors use leverage:

• Companies borrow to finance expansion, acquisitions, or capital projects instead of issuing new shares.
• Investors use margin accounts, options, futures, and other instruments to increase market exposure with a smaller cash outlay.
• Indirect exposure to leverage is possible by investing in firms that themselves use debt.

The goal is to earn a return on the borrowed capital that exceeds the cost of borrowing. If returns fall short, leverage magnifies losses and can strain cash flow and solvency.

Common leverage ratios and how to calculate them

A variety of ratios evaluate how much debt an entity carries and how that debt relates to assets, earnings, and equity.

Debt ratio
* Formula: Debt Ratio = Total Debt ÷ Total Assets
* Interprets what portion of assets is financed with debt. A ratio of 1.0 means $1 of debt per $1 of assets.

Debt-to-equity (D/E) ratio
* Formula: Debt-to-Equity = Total Debt ÷ Total Equity
* Compares borrowed funds to owners’ equity. A D/E > 1 indicates more debt than equity but context matters by industry.

Debt-to-EBITDA ratio
* Formula: Debt-to-EBITDA = Total Debt ÷ EBITDA
* Measures debt relative to operating cash-generation capacity. A higher ratio indicates heavier debt burden.
* Note: EBITDA is a non-GAAP measure and can overstate cash flows if material expenses are excluded.

Equity multiplier
* Formula: Equity Multiplier = Total Assets ÷ Total Equity
* Used in DuPont analysis to show how asset financing affects return on equity. Larger multipliers suggest greater use of leverage.

Degree of Financial Leverage (DFL)
* Formula: DFL = % Change in Earnings Per Share ÷ % Change in EBIT
* Shows how sensitive EPS is to changes in operating income; higher DFL implies more volatility in EPS from operating income swings.

Consumer leverage
* Formula: Consumer Leverage = Total Household Debt ÷ Disposable Income
* Indicates household indebtedness relative to income; high levels can hinder future borrowing and increase default risk.

Fast fact: Leverage ratios are most informative when compared across time or against industry peers.

Example

A company starts with $5 million in equity and borrows $20 million, giving it $25 million to deploy.

• Debt-to-equity = 20 ÷ 5 = 4.0 (four dollars of debt per dollar of equity)
• Debt-to-assets = 20 ÷ 25 = 0.80 (80% of assets financed by debt)
• Equity multiplier = 25 ÷ 5 = 5.0

Interpretation depends on industry norms. High leverage can support fast growth when returns exceed borrowing costs but adds risk if revenues fall.

Margin vs. leverage

Margin is a specific form of leverage: borrowing from a broker using cash or securities as collateral to increase buying power. For example, a 1:10 margin (10x leverage) means $1,000 of collateral can be used to purchase $10,000 of securities. Margin involves interest, maintenance requirements, and potential margin calls.

Advantages and disadvantages

Advantages
* Amplifies returns, enabling greater profit potential from successful investments.
* Lowers barriers to entry for more expensive opportunities.
* Allows companies to seize time-sensitive growth or acquisition opportunities without issuing equity.

Disadvantages
* Amplifies losses and can produce losses larger than initial capital.
* Involves additional costs: interest, fees, premiums, and margin requirements.
* Increases complexity and requires ongoing monitoring and potential additional capital if positions move against you.

How to assess whether leverage is appropriate

• Compare leverage ratios to industry peers and the company’s own history.
• Evaluate the stability of cash flows and the company’s ability to service interest and principal.
• Consider macroeconomic and market conditions that affect borrowing costs and revenue visibility.
• Use conservative scenarios and stress tests to understand downside risk.

Bottom line

Leverage is a powerful tool for increasing returns and financing growth, but it increases financial risk and complexity. Whether to use leverage depends on industry norms, the predictability of cash flows, borrowing costs, and the investor’s or company’s capacity to absorb losses. Careful measurement, monitoring, and contingency planning are essential when employing leverage.