Market leverage with linked plans

Table of Content

1. Understanding Leverage

2. Understanding how leverage works

3. Leverage Formulas

4. Disadvantages of Leverage

Understanding Leverage

Leverage is an investment strategy of using borrowed money, specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. It results from borrowed capital as a funding source.

Understanding how leverage works

Leverage is using borrowed capital to undertake an investment or a project. Leverage is used by investors and companies both. Companies use leverage to finance their assets. Investors use leverage to increase the returns on their investment.

Leverage Formulas

Through the help of balance sheet analysis, various investors are able to study the debt and equity on the books of firms and can therefore invest in companies that put leverage to work on behalf of their businesses. Statistics such as return on equity, debt to equity and return on capital employed help investors determine how companies deploy capital and how much of that capital companies have borrowed. In order to properly evaluate these statistics, it is important to understand that leverage comes in several varieties, including operating, financial and combined leverage.

In case of fundamental analysis, degree of operating leverage is used. You can calculate the degree of operating leverage by dividing the percentage change of a company's earnings per share by its percentage change in its earnings before interest and taxes over a period. A higher degree of operating leverage means a higher level of volatility in a company's EPS.

Disadvantages of Leverage

Leverage is a complex tool which magnifies both gains and losses. The use of leverage can be profitable but the reverse is also true. If an investor uses leverage to make an investment and the investment performs against the investor, the loss that they face is far greater than it would've been if they had not leveraged the investment. Similarly, a company can use leverage to create shareholder wealth, but when it fails to do so, the interest expense and credit risk of default can destroy shareholder value.

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