Financial Leverage Explained: How Borrowing Can Maximize Returns

2024-09-22Last Updated: 2024-09-22

In finance, using debt to get more returns is a strategy used by individuals and companies alike. Financial leverage is using borrowed money to increase the potential return on investment. Understanding financial leverage is key to making good financial decisions and growing your wealth.

What is Financial Leverage?

Financial leverage is using borrowed money (debt) to get more returns. By using debt an investor or a company can increase their investment capacity without having to put up more of their own money. This is based on the idea that the returns from the investment will be more than the cost of the borrowed funds.

How Does Financial Leverage Work?

Let’s use a simple example to illustrate how financial leverage works:

You have $10,000 to invest in a business venture. If you invest this amount without borrowing, your returns are limited to what this $10,000 can generate. But if you borrow another $10,000, your total investment capacity is now $20,000. If the business venture returns 10%, your returns would be:

Without leverage: $10,000 x 10% = $1,000
With leverage: $20,000 x 10% = $2,000

By using financial leverage you have doubled your returns but you need to consider the cost of borrowing (interest). If the cost of borrowing is 5%, the net return would be:

With leverage: ($20,000 x 10%) – ($10,000 x 5%) = $2,000 – $500 = $1,500

In this case financial leverage has increased your net returns from $1,000 to $1,500.

Benefits of Financial Leverage

Increased Investment Capacity: Financial leverage allows investors and businesses to increase their investment capacity without having to put up more of their own money. This is particularly useful for businesses looking to expand or individuals looking to diversify their investment portfolios.
More Returns: As shown above financial leverage can get you more returns. When used wisely it can magnify profits and accelerate growth.
Tax Benefits: In many countries the interest paid on borrowed funds is tax deductible. This can reduce the cost of borrowing and get you more net returns.
Growth Opportunities: Financial leverage can provide businesses with the funds to take advantage of growth opportunities such as expanding into new markets, launching new products or investing in research and development.

Risks of Financial Leverage

Leverage is great but not without risk. Here are the risks:

Debt Burden: Borrowing increases debt. If the investment doesn’t perform as expected, you still have to pay back the debt plus interest which can be a strain on your finances.
Interest Rate Risk: Changes in interest rates can affect the cost of borrowing. If interest rates go up, the cost of servicing the debt goes up which can reduce returns or even lead to losses.
Market Volatility: Investments are volatile. In bad markets, leveraged investments can multiply losses and put a big strain on your finances.
Credit Risk: The ability to borrow depends on your creditworthiness. Bad credit can mean higher borrowing costs or no access to funding.

How to Calculate Financial Leverage

There are several ways to calculate financial leverage.

1. Debt-to-Equity Ratio

This one compares total debt to total equity. Here’s the formula:

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

For example, if a company has a debt-to-equity ratio of 0.5, it means it has 50 cents of debt for every dollar of equity.

Interpretation:

Low (< 1): Low debt to equity means the company or individual is funded by equity (own money) rather than debt. This is a conservative approach to funding, lower risk.
Medium (1-2): Medium means balanced between debt and equity. This is good risk vs return, as long as the borrowed funds are used to generate higher returns.
High (> 2): High debt to equity means heavy debt. This is higher risk, as the company or individual must be able to service the debt. But can also mean higher returns if the borrowed funds are invested wisely.

2. Debt Ratio

This one measures the percentage of total assets that are financed by debt. Here’s the formula:

Debt Ratio = Total Debt / Total Assets

For example, if an individual has a debt ratio of 0.6, it means 60% of their assets are financed by debt.

Interpretation:

Low (< 0.5): Less than half of assets financed by debt. Lower risk, stronger equity.
Moderate (0.5-0.7): Balanced approach to financing. Debt finances a big chunk of assets, but still has strong equity.
High (> 0.7): More than half of assets financed by debt. Higher risk, needs to manage debt well to avoid distress.

3. Equity Multiplier

This one measures the percentage of a company’s assets that are financed by shareholders’ equity. Here’s the formula:

Equity Multiplier=Total Assets / Total Equity

For example, if a company has an equity multiplier of 2.5, it means it has $2.50 in assets for every dollar of equity.

Interpretation:

Low (< 2): Low equity multiplier means you are mostly funded by equity, lower risk and more conservative use of debt.
Moderate (2-3): Moderate equity multiplier means you are using both debt and equity to fund assets, potentially higher returns and managed risk.
High (> 3): High equity multiplier means you are using a lot of debt to fund assets. Higher risk but higher returns if used well.

You need to understand financial leverage ratios to know the financial health and risk of a company or individual. By looking at ratios like debt to equity ratio, debt ratio and equity multiplier, you can see how debt is being used and what it means to financial stability and returns.

The Bottom Line

Financial leverage is a powerful way to get more returns. By using borrowed money investors and businesses can increase their capacity to invest, get more returns and grab opportunities. But you need to carefully consider the risks of financial leverage – debt burden, interest rate risk, market volatility and credit risk.

Used wisely and with full understanding of its consequences, financial leverage can be a game changer in achieving your financial goals and growth. Whether you are an individual or a business, mastering financial leverage can help you make informed decisions.

More Resources

Thank you for reading our guide to financial leverage. To keep learning and developing your knowledge of finance, we highly recommend the additional resources below: