Leverage Definition in Business

Leverage is borrowing funds from a third party against a company’s assets. This allows a profitable company to put more money behind its rising stocks. However, a company that becomes unprofitable will experience leverage as a burdensome debt load that can drive a company into insolvency.?

Leverage can help a company boost its earnings via careful loan acquisitions during bullish market periods.

The precise leverage meaning: Leverage can help make a company more profitable, but it can also backfire and result in considerable debt.?

What Is Leverage in Business?

In business, leverage means borrowing money to increase business capital and assets — applying outsized “force” to relatively small assets by adding outside capital.?

Leverage amasses “force” on a company’s side to perform financial heavy lifting — acquiring new assets and making updates that it could not without borrowed money.

A “highly leveraged” company is a company with more debt than equity. And that is the downside of leverage: We are, after all, talking about a large loan a company must pay back within a time frame. An equity-poor company is going to have a difficult time doing that.?

The Difference Between Leverage and Margin

Leverage and margin are similar concepts, but there are some key differences to note:

• Margin. The room you have to borrow against cash, securities, and assets when trading stocks.?
• Leverage. The increase in trading power results from the intelligent use of your margin.?

Leverage Ratios and How to Use Them

Leverage ratios assess whether a company can meet its financial obligations.?

A leverage ratio exists to examine a business’s debt-to-equity ratio from several angles: in terms of assets (balance sheet), income generated, etc.?

The most common debt ratios are:?

• Debt-to-Assets Ratio = Total Debt divided by Total Assets
• Debt-to-Equity Ratio = Total Debt divided by Total Equity
• Debt-to-Capital Ratio = Total Debt divided by (Total Debt plus Total Equity)
• Debt-to-EBITDA Ratio = Total Debt divided by Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
• Asset-to-Equity Ratio = Total Assets divided by Total Equity

Know how much leverage you are working with when assessing business information. A high amount of leverage can be risky, although it can also be leveraged in a company’s favor — in the acquisition of assets, for instance, or to initiate large-scale company changes.?

What Are Some Types of Leverage?

• Operating leverage. The ratio of fixed costs to variable costs. Fixed costs remain constant — things like insurance payments or office block rent. Variable costs change based on how a firm is performing. Labor, materials, and changes in day-to-day operational costs vary based on a successful firm’s enlarged output or an unsuccessful one’s diminished output. High operating leverage indicates a large proportion of fixed costs — and makes a business “capital intensive.” This can be problematic when high fixed costs are not outpaced by earnings.
• Financial leverage. The amount of debt a company has used or plans to use. If profit is greater than the interest paid on loans, a company can see a greatly improved return on equity and earnings per share. Excessive use of financing, however, can lead to default and bankruptcy.?
• Combined leverage. The combination of operating leverage and financial leverage. Operating leverage influences operating income, whereas financial leverage assesses stockholders’ earnings per share. A company lays this out on its balance sheet and income statement.

How to Use Leverage

When a company’s profits are on the upswing, it can use leverage for a boost.?

Say a stock is on the rise. Borrowing money — acquiring leverage — allows you to invest more in that rising stock, which means higher returns.?

On the other hand, if a highly leveraged company’s profits decline, it risks insolvency and the inability to repay its debts. This is not good for its credit: A high debt-to-income ratio makes it harder for a firm to get loans in the future.?

The Bottom Line of Leverage

Leverage can be a great way for a company on the rise to shoot to the top. By carefully leveraging stock assets, keeping variable costs low, and knowing one’s debt-to-income ratio, a company can succeed like never before.?

But leverage is not a great way for an unsuccessful company to rescue itself from drowning.?

Shareholders must determine whether a company will benefit from leverage using careful analysis of their sector’s business trends, as well as their company’s current income expectations and asset values.

Key Takeaways:?

• Leverage is borrowing third-party funds against a company’s assets.?
• Leverage can drive rising profits.?
• There are various kinds of leverage and positives and negatives to acquiring it.?

(Reporting by NPD)