LeverageThe use of debt financing, or property of rising or falling at a proportionally greater amount than comparable investments. For example, an option is said to have high leverage compared to the underlying stock because a given price change in the stock may result in a greater increase or decrease in the value of the option. Also, commonly known as Gearing in Europe.Leverage

1. To use debt to finance an activity. For example, one usually borrows money in the form of a mortgage to buy a house. One commonly speaks of this as leveraging the house. Likewise, one leverages when one uses a margin in order to purchase securities.

2. The amount of debt that has been used to finance activities. A company with much more debt than equity is generally called "highly leveraged." Too much leverage is thought to be unhealthy, but many firms use leverage in order to expand operations.

Leverage. Leverage is an investment technique in which you use a small amount of your own money to make an investment of much larger value. In that way, leverage gives you significant financial power.

For example, if you borrow 90% of the cost of a home, you are using the leverage to buy a much more expensive property than you could have afforded by paying cash.

If you sell the property for more than you borrowed, the profit is entirely yours. The reverse is also true. If you sell at a loss, the amount you borrowed is still due and the entire loss is yours.

Buying stock on margin is a type of leverage, as is buying a futures or options contract.

Leveraging can be risky if the underlying instrument doesn't perform as you anticipate. At the very least, you may lose your investment principal plus any money you borrowed to make the purchase.

With some leveraged investments, you could be responsible for even larger losses if the value of the underlying product drops significantly

Leverage

The effect borrowed money has on an investment; the concept of borrowing money to buy an asset that will appreciate in value, so that the ultimate sale will return profits on the equity invested and on the borrowed funds.

Example: Mark and Amy each have $100,000 to invest. They can buy rental houses for $100,000 per house and collect rent of $1,100 per month for each house. At the end of 5 years, they will be able to liquidate and sell their houses for $150,000 each. Amy uses leverage and Mark does not.

Leverage

What Does Leverage Mean?

(1) The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

(2) The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered highly leveraged.

Investopedia explains Leverage

(1) Leverage can be created through options, futures, margin, and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, or you could increase your leverage by buying five option contracts worth $1,000. You then would control 500 shares instead of 10. (2) Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, a company started with an investment of $5 million from investors has equity of $5 million; this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders. Leverage helps both the investor and the firm invest and operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would have been if the investment had been made with cash; leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default can destroy shareholder value.

LEVERAGE RATIOS

Debt to Assets Ratio = Total Liabilities/Total Assets

Debt to Equity Ratio = Total Liabilities/Total Equity

Times Interest Earned = Operating Income/Interest Expense

A leverage ratio is a comparison of a combination of a company's debt, equity, assets and interest payments to ascertain its long-term solvency and ability to meet its financial obligations. Leverage, or gearing, refers to the use of loans or other forms of debt to finance acquisitions or investments. The goal of using these financing options is to earn a higher rate of return than the rate of interest on the loan and amplify gains. Companies with a high degree of leverage are considered risky and highly vulnerable to economic downturns because they must continue to meet obligations to the debt in spite of poor production or sales.The three most commonly employed leverage ratio formulae are the debt-to-equity ratio, thedebt ratio, and interest-coverage ratio. Acceptable leverage ratios are determined by comparison to ratios of other entities in the same industry. They are also determined by tracking of the same ratio for one company over time.AdChoices

The debt-to-equity ratio is the most commonly used leverage ratio, providing a measure of a company's liabilities in relation to the funds given by shareholders. A greater proportion of shareholder capitalization provides a safety net and is viewed as a sign of financial strength. This ratio is calculated by dividing the total debts by the total equity of the shareholders. The lower the number, the less gearing or leverage that the company is using. Since the leverageratio is used to assess long-term solvency, many companies deduct the accounts payable, a short-term debt, from the total debt figure before completing the ratio calculation.Another type of leverage ratio, the debt ratio or debt-to-asset ratio, indicates what portion of the company's assets is financed by debt. The debt ratio is determined by dividing the company's total debts by its total assets. A higher debt ratio signifies a higher degree ofleverage used by the company. The operating liabilities are often deducted from the total debts before calculating the ratio.Alternatively, the interest-coverage ratio indicates the relative ease with which a company can pay the interest associated with its debt. The formula divides the amount earned per share by the interest expenses, before interest and taxes are subtracted from the earnings. In general, an interest-coverage ratio of less than two is a red flag that the company may be unable to fulfill its interest obligations. This ratio is monitored as a critical indicator of a company's viability since even a deeply indebted company may be able to make its interest payments. Once this ratio falls, default or bankruptcy may be imminent.