Financial Leverage

Attempting to Balance Financial Risk and Reward

In the financial sense, leverage is the process by which a business person, entrepreneur or investor is able to greatly increase the return on an investment through the use of borrowed money.

A conservative investor, defined here as one who does not like risk, makes a secure loan to another person or business that is willing to take a great deal of risk.

For the conservative investor this is a chance to get the investment back plus interest – there is little risk of losing the principal loaned and the modest rate of return assured.

The risk taker who is borrowing the money will use the money for a high risk investment that promises a big return but also has a high potential for total loss of the investment. For the risk taker the lever is the degree of risk taken.

Sculpture of Bag of Money in a wagon
Sculpture of Bag of Money in a wagon | Source

Defining Leverage

Before continuing, let's take a look at the term leverage itself and see how the concept of leverage is basically the same whether we are using it in the mechanical or financial sense.

Leverage refers to increasing force by use of a lever. A lever is simply a device which increases, or multiplies, the force of energy applied as distance is increased.

This is the mechanical definition of leverage as developed by Archimedes in the third century B.C. A simple, every day, example of lever and the principle of leverage is the teeter totter (or seesaw in some places) on a playground.

It takes great effort to lift up the end where the person (even if a child) is sitting, but very little effort to lift the person up when you push down on the other end.

In this case the lever is the board and, by increasing the distance along the board between you and the person sitting at the other end, the amount of energy (effort) required to lift becomes easier and easier.

Archimedes claimed that, with a long enough lever, a single individual could lift the entire world.

In mechanics, the longer the distance, the less energy needed to complete the same amount of work.

Think of a wrench – it takes considerably more energy to loosen a nut if you hold the wrench at the neck, close to the nut, but, if you hold the wrench further away along the handle, very little energy is needed to loosen the nut.

Financial Leverage

In the financial world, leverage is the amount of risk a person is willing to take.

The greater the risk, the greater the potential payoff. Of course, the greater the risk the greater the investor's chance of losing the investment which is why not everyone uses financial leverage and, of those who use it, why many fail.

There are only two things that can be done with money – spend it or invest it.

Spending involves near zero risk. A person receives his paycheck, goes to the bank where he cashes it for a combination of cash and cashier's checks (or money orders) payable to his creditors for bills due and then goes to the mall and spends the rest on goods he wants or needs. Little chance of loss here.

If he applies a small amount of leverage by holding some of the money while he shops around for a better deal on goods, thereby having some cash left over for other things, he incurs some risk in having it lost or stolen but is also able to buy more as a result of finding deals on what he needs.

Putting the money in a government insured bank account, investing in a U.S. Treasury security, investing in a high quality corporate bond, etc. all involve increasing the risk slightly but also produce a return in the form of interest.

With each of these investments there is a slight risk of loss as well as the risk of dying and not being able to enjoy the use of the m.

Since both the risk and rewards in these examples are very small, the concept of financial leverage, as commonly used, does not apply other than to illustrate the point that everyone of us uses leverage, with the difference between the average worker and the big time speculator on Wall Street or in the City (London financial district) being a matter of degree.

So, what are some types of serious financial leverage and how do they work? Here are some examples:

Purchasing Stock on a Margin

Buying Stocks on the Margin: this involves borrowing money from a stockbroker and using it to purchase shares of stock.

The stock becomes the security for the loan and the investor pays, in addition to the usual broker fees for buying and selling shares of stock, interest on the money borrowed.

If 100 shares of stock are purchased at $10 per share and the shares then increase to $20 per share within the next couple of weeks, the investor sells the 100 shares for $2,000, repays the broker the $1,000 borrowed to purchase the stock and, after paying the broker the interest due on the loan plus the buying and selling fees, pockets a profit of close to $1,000.

Of course, if the stock goes down, rather than up, in price the investor faces what is known as a margin call. With this the investor has to either immediately repay the broker the difference between the original price of the stock (which is what she originally borrowed) or have the broker sell the stock to prevent further loss. The investor is still liable to the broker for the amount of the decline in price plus interest and broker fees.

When you hear stories about men jumping out of the windows of their offices after receiving a telephone call from their stock broker (or see it in old movies) during the 1929 U.S. stock market crash, these were the result of margin calls. Only here, these people had in many cases mortgaged their homes to purchase stock and then borrowed against the stock to buy more stock.

These investors were highly leveraged. However, some, like Bernard Baruch and Joseph Kennedy (father of President John F. Kennedy), made fortunes this way and got out of the market early, while others, who knew little about investing but assumed stock prices could only go up, lost everything through margin purchases.

Options

Options: An option is the right to purchase a piece of property (stock, real estate, etc.) at an agreed upon price during an agreed upon time frame.

Options can be used to either speculate, in which the speculator expects the price to rise, or to hedge (insure) against a rise in price.

For instance, a speculator may feel that the price of a stock will rise within the next few months or that land prices will rise in the near future and is therefore willing to pay the owner for the right to purchase the stock or real estate (or other property) at a price they agree upon now.

Generally the agreed upon price is higher than the current price. If the price rises above the agreed upon price within the life of the option, the speculator pays the agreed upon price, immediately sells it at the higher market price and pockets the profit.

If the price doesn't rise, the option expires and the speculator loses the price paid for the option (however, the buyer of the option, whether price of the property rises or falls, saves having to tie his own money up in buying the property and holding it in anticipation of its rising).

Investing in stock options in the United States is very easy as these are now listed on the major stock exchanges and can be brought and sold anytime during the life of the option.


Selling Stock Short

Short Sales: A short sale involves a speculator contacting his broker and selling the stock owned by another investor (the other investor agrees before hand to allow this and receives compensation when the stock is used in this manner).

The assumption here is that the stock is about to fall in price. If the stock falls as expected, the speculator purchases it at the new, lower, price, restores it to the owner and pockets the profit.

HOWEVER, if the price rises, the speculator is forced to purchase it at the new, higher price, restore it to the owner and has a loss.

Business Borrowing

Businesses, whether large global corporations or sole proprietors, can increase their profits by leveraging their business through borrowing.

All businesses need money and there are only two ways to get money. The two ways are from investors (who receive a proportionate share of ownership and profits as a result) or borrowing (in which the lender receives interest and a promise to repay the principal at a future date).

Leverage in a business refers to the portion or percent of debt to equity (equity is the value of what the owners of the business have invested in the business). The greater the percent of debt to equity the more highly leveraged the business is said to be.

When investing one's own money and that of investors in a business the risk is limited to the loss of each person's investment. If I need $5,000 to start a business and take that money from my savings account then the most I lose if the business fails is the $5,000 from savings. If the business is a success, I get to keep all of the profits.

However, assume I can produce ten times as much product and make ten times as much profit by investing $50,000, but lack the remaining $45,000. If I get nine friends to each put up $5,000 in return for one tenth of the business each and the business works as planned, the business makes ten times the profit but my one-tenth share is the same as if I had kept the business at the $5,000 level and I get no more than one-tenth the profit as the other nine-tenths goes to my friends who invested $5,000 each.

However, suppose I get my friends to loan me the $5,000 each at 10% interest. If the business succeeds as expected, I can pay my friends the $500 each in interest as well as pay down the $45,000 they loaned me out of the profits each year. This will be a drag on my profits initially but as soon as the loans are repaid these expenses disappear and I am left as the sole owner of a $50,000 business.

Of course, if the business fails I am in debt to my friends for $45,000 plus interest. The greater the risk, the greater the leverage which translates into greater profits when successful and a greater loss if unsuccessful.

Again, whether we are speaking of a global corporation or sole proprietorship, the higher the leverage of debt to equity the greater the risk of the business but also the greater the potential profit for the owners.

When buying shares of stock in a company, your share of any profit will be much greater the more the company is leveraged – of course, your chance of losing your investment if the company goes bankrupt is also greater.

How Do You Feel About Leveraged Investments

Do You Feel About Leveraged Investments

  • I prefer small, safe returns and don't like to risk my money.
  • Risk is fine so long as I can study the investment and determine the odds of success.
  • I don't understand investing and prefer to keep my money in cash at home.
See results without voting

© 2006 Chuck Nugent

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36 comments

Chuck profile image

Chuck 20 months ago from Tucson, Arizona Author

Low Check Kian - Glad you enjoyed the Hub. Thanks for visiting.


Low Check Kian profile image

Low Check Kian 21 months ago from Singapore

this is a very nice hub


monicamelendez profile image

monicamelendez 4 years ago from Salt Lake City

For example, instead of buying a single home as an investment property, you could buy two, borrowing half of the money. Both your upside and downside are increased through leverage.


monicamelendez profile image

monicamelendez 4 years ago from Salt Lake City

You can do a lot of leveraged investing in real estate as well!


Subjectmoney 4 years ago

So many people think of financial leverage as a bad thing but it can really increase a company or an individuals ROE. The goal is to find an optimal amount of financial leverage and not take on so much debt that there is a risk of financial distress.

http://www.subjectmoney.com/definitiondisplay.php?...


ilitek profile image

ilitek 5 years ago

Leverage is a double edge sword


htodd profile image

htodd 5 years ago from United States

This is great hub,Nice


Jokylu profile image

Jokylu 5 years ago from Waratah North, Victoria.

Thankyou for a very clear, and concise hub explaining leverage in an easy to read way. Well done


Sinea Pies profile image

Sinea Pies 5 years ago from Northeastern United States

Great hub. I feel so sub-par when it comes to investing. This was very helpful to help me understand the "strange land" of finance! Voted up and useful.


orchid on earth 5 years ago

thank u v much 4da info..........it help me a lot 2 prepare my answer.

thank you


crystolite profile image

crystolite 5 years ago from Houston TX

very useful information well done


james moylan  5 years ago

I have a web site where I cover stocks under 5 dollars. I have been following stocks under 5 dollars for a very long time.low price stocks can have tremendous leverage using leverage in your investments is a double edge sword.


Chuck profile image

Chuck 5 years ago from Tucson, Arizona Author

Howard S. - Thanks for catching this. My general practice is to write my Hubs off line in a word processor and, after editing and spell checking, post the content to HubPages.

I obviously posted part of it twice and did not proofread the final work as carefully as I should have.

This has now been corrected and I thank you again for bringing this to my attention.


Howard S. profile image

Howard S. 5 years ago from Dallas, Texas, and Asia

Is it just my browser? How come no-one else noticed: Everything from the 8th paragraph to the subhead is repeated (inadvertently, of course) below the subhead.

I like your articles in general, Chuck.


Mr. Fisherman 5 years ago

Excellent. Thanks for sharing.

http://bangusfarmers.blogspot.com


hubbcapp profile image

hubbcapp 5 years ago

excellent information. it is a great help with what I do. thanks for putting it on here to share with others.


kubth profile image

kubth 6 years ago from UK

Great Hub with excellent information.


Sekharg profile image

Sekharg 6 years ago from USA

Liked the examples.


kingkhan78 profile image

kingkhan78 6 years ago

interesting information about Financial Leverage thanks for sharing


Justin 6 years ago

Good hub, great read..


Richard Stephen 6 years ago

Very good hub Chuck! You have a gift for explaining things in a way that is easily understood. I've fielded several questions on leverage lately especially from those interested in getting into Forex investing. Forex, as you probably know, is a heavily leveraged market. I've tried to explain to them the risks of highly leveraged investing but know I think I will just point them to your hub. Keep up the good work!


marina martinez 6 years ago

wow that's a WOW


LasanthaW profile image

LasanthaW 6 years ago from Sri Lanka

Good article.


LeanMan profile image

LeanMan 6 years ago from At the Gemba

Good explanation.. Well written hub, thanks for the info


lender3212000 profile image

lender3212000 6 years ago from Beverly Hills, CA

Great article! The power of leverage in the financial markets can be huge as long as you stay on the right side of it. It can also turn against you in a hurry so you have to be willing to stay on top of things and actively manage your open transactions.


Mitch King profile image

Mitch King 6 years ago from Wilsoville, OR, USA

Very well written. You have done a good job of explaining leverage and risk for those who are wanting to know more about finance.


ciidoctor profile image

ciidoctor 6 years ago

very good hub


Darren2010 profile image

Darren2010 6 years ago

This is another winner, good job.


mike8178 6 years ago

Good hub page, here have a look at http://financialcentreuk.co.uk for more financial leverage iedas


bobmnu profile image

bobmnu 7 years ago from Cumberland

Chuck - I have gotten into the stock market in the past year and it is exciting. 

I have learned so much about the business world by researching some of my investments and learning how the stock market works. 

Thanks for another good hub.


Chuck profile image

Chuck 7 years ago from Tucson, Arizona Author

jayb23 - thanks for the comment. Given your background, that really means something. Thanks again.

Chuck


jayb23 profile image

jayb23 7 years ago from India

Brilliant Hub, being an MBA Finance myself, I finally read a nice hub which explained the basics pretty well. Good work Chuck


sophieqd profile image

sophieqd 7 years ago

Financial_Leverage

excellent hub.I like it.


pkoson profile image

pkoson 7 years ago

Financial_Leverage

I think this hub is the anti-anti-toxin to anxiety! Help, the verbosity of it is making me anxious!


Bernard 9 years ago

Yes, leverage is the quickest way to build your wealth.

Robert Kiyoskai in his "Rich Dad, Poor Dad" mentioned that the rich understood the power of leverage. They leverage on other people's money and time.


Amy Goodmann 9 years ago

excellent article

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