In finance terminology, the mechanism that enables more investments with a smaller amount is called leverage or leverage. A common practice of leverage in financial transactions means that an investment is financed by debt rather than equity to maximize its return.
What is Financial Leverage?
Financial leverage is a measure that shows the effect of the change in operating profit on earnings per share. Financial leverage is the firm’s ability to use debt in order to increase its net profit. By taking advantage of financial leverage, the Firm can achieve a higher increase in net profit versus a 1 unit increase in operating profit. The effect of financial leverage is measured by the degree of financial leverage (DFL).
The more resources the firm has to generate financing expenses such as bank debt and bonds among the total resources financed by its assets, the higher the degree of financial leverage will be. Firms with high indebtedness and therefore financial leverage will have a high financial risk as they will be liable to pay principal and interest. In other words, companies want to earn high profits in return for the high financial risk they undertake. However, high financial risk may cause the firm to face bankruptcy or default during periods of cash shortage.
In addition, due to increased indebtedness and financial risk, when the firm needs new resources, debt and equity costs may increase. This situation is handled from different angles in the capital structure theories. Banks are examples of institutions that use high financial leverage because banks place deposits they collect as loans to their customers or loans they receive from other institutions. For this reason, the banking sector in the world is the sector that is mostly subject to financial regulation and supervision.
What is Leverage in Financial Transactions?
Investors and companies use leverage as an investment strategy. If the expected return on an investment is greater than the cost of financing (interest and other fees), the investment is financed by debt and the greater risk is taken, thus maximizing the expected return on the investment.
The leverage ratio, which is among the important financial ratios and calculated in various ways, shows how a company’s assets are financed and its ability to pay its debts.
Leverage also refers to the debt that investors receive from brokerage houses at a certain leverage ratio by depositing the necessary collateral to invest in underlying assets such as currency and gold derivatives in various financial markets.
Leverage in the Forex Market
Mary uses $ 500,000 in cash to purchase 40 acres of land with a total cost of $ 500,000. Mary is happy not to use financial leverage.
Sue uses $ 500,000 in cash and borrows $ 1,000,000 to buy 120 acres of land for a total cost of $ 1,500,000. Sue uses financial leverage with only $ 500,000 of her own money to own / control $ 1,500,000 in property. Also suppose that Sue’s loan is $ 50,000 annually and is paid at the beginning of each year.
What Are the Effects of Using Financial Leverage?
For our examples, suppose that one year later the value of land owned by Mary and Sue increased by 20% and that both Mary and Sue sold their land investments at market value. As a result:
- Mary’s land will be sold for $ 600,000, resulting in a gain of $ 100,000 ($ 600,000 selling price minus $ 500,000 for the land’s cost). The $ 100,000 gain from Mary’s $ 500,000 cashback results in a 20% gain on Mary’s $ 100,000.
- Sue’s land will be sold for $ 1,800,000, resulting in a profit of $ 250,000 ($ 1,800,000 minus $ 1,550,000, the cost of the land is $ 1,500,000, and the interest is $ 50,000). The $ 250,000 gain from Sue’s $ 550,000 in cash is 45% gain instead of 20% gain without leverage.
Now suppose that a year later the land owned by Mary and Sue has depreciated 20% and both Mary and Sue sell their land investment at market value. As a result:
- Mary’s land will be sold for $ 400,000, which means a loss of $ 100,000 in the $ 500,000 cost of the land. Mary’s $ 500,000 loss of $ 100,000 in cash results in a 20% loss in Mary’s money.
- Sue’s land will be sold for $ 1,200,000, resulting in a loss of $ 350,000 ($ 1,200,000 selling price minus $ 1,500,000 cost of the land and $ 50,000 in interest). A loss of $ 350,000 in Sue’s $ 550,000 cash results in a 63.6% loss in Sue’s money, rather than a 20% loss without leverage.