Defining a leverage
Leverages are debts generated when a business is in an expansion phase. It is usual for any business to aim for growth since it is a way to create more potential returns. Investors or companies will look for creditors to give them funds or capital to make an expansion or a project possible. We call this strategy leverage. Leverages help investors increase their buying power.
How Leverage Works
We can say that leverage is a borrowed money used by investors and companies to pay for a project or an expansion when they cannot provide money upfront.
In short, leverage is like any other type of debt, such as credit cards and loans. An entity borrows money and promises to pay it at a specific time. And just like any other debt, it also increases the chance of bankruptcy. If the leverage’s purpose, like a project or an expansion, becomes successful, then the return of equity increases.
Companies will usually go for leverage. However, if they decide to avoid it because of the fear of risks and massive debts, they can also consider equity financing. Equity financing is giving a part of the company’s ownership to buy or do something. In public traded companies, they would need to provide shares.
Different types of leverages
There are several types of leverages that entities use in breakeven analysis and capital structure development. Listed below are the general kinds of leverages:
- Financial leverageslend money to companies to increase their returns without giving a part of the ownership. However, it also comes with high risks that can lead to bankruptcy because of too many debts. The debt/ equity ratio is a financial ratio that evaluates if the company has more debts than equities or vice versa.
- Operational leveragesare debts that refer to the expenses to provide a product or a service. If we look at a breakeven analysis, we can see two types of company costs: fixed and variable costs. To sum it up, operating leverage means the fixed costs’ ratio of costs.
- Combined leverage, also known as total leverage, is the amount of all risks, hence the name combined leverage. It is the combination of operating leverage that identifies the fixed assets and costs and financial leverage. Combined leverage seeks to account for all risks and the whole amount of leverage that shareholders can use representing the company.
The downside of using leverages
Investors and companies indeed consider leverage as a method to gain funds for good intentions like projects and expansion that might provide a higher return. However, even if leverage might create a possibility of gains, if not executed correctly and things go downhill, it might also make a possibility of significant losses more than profits.
There is a term called highly leveraged. It means that a company, investment, or property that used leverage has more debts than equity. The worst-case scenario might be bankruptcy. So, it is wise for new investors to know and gain more experience in investments first before resorting to leverages due to this reason.