Financial leverage is essentially using other people's money (or promised money) to make an investment of greater value that you could otherwise afford with the cash you have.
The most common form of leverage that many people are familiar with is a mortgage. When we buy a piece of real estate with a mortgage, we are only paying a portion of the cost with our own money while the bank is providing the rest of the funds. The more you borrow relative to the portion you put in yourself, the more leveraged you are said to be.
Leverage can be both extremely useful as well as extremely risky. Let's look at how leverage can help you make greater returns on your equity in the right circumstances.
Let's pretend I want to make an investment that I believe will generate 20% interest in 1 year.
Let's say that I have $1000 of my own capital to invest.
Let's also assume the bank is willing to loan me money at 5% interest, but they won't lend me more than the amount that I also invest.
Scenario 1: No leverage
If I didn't borrow any money, I can invest $1000 and after 1 year I have:
$1000 (My original investment) +
$200 (The interest on my investment at $1000 * 20%)
Total = $1200
Overall yield on invested capital = 20%.
Scenario 2: With Leverage
If I take the loan from the bank of $1000, I now have $2000 to invest. After 1 year I have:
$2000 (The original investment) +
$400 (The interest on my investment at $2000 * 20%)
Total = $2400
I still have to pay back the bank:
$1000 (The original loan amount) +
$50 (Interest on the loan at $1000 * 5%)
Total to be repaid = $1050
My final position after paying the bank:
$1350 ($2400 - $1050)
This means that my total gain is $350.
Overall yield on invested capital = 35%
Leverage Risks
The above scenarios show a positive view of leverage as a way to increase investment returns. However let's assume we were able to borrow $9000 from the bank, not just $1000. This allows us to make an investment of $1000. And let's also assume that our risky investment loses only 10%.
So at the end of 1 year I have:
$9000 (The original investment less 10%)
I still have to pay back the bank:
$9000 (The original loan amount) +
$450 (Interest on the loan at $9000 * 5%)
Total to be repaid = $9450
My final position after paying the bank:
-$450 ($9000 - $9450)
So my total loss is:
$1000 (my entire initial investment) +
$450 (the portion of the bank loan I cannot repay)
Overall yield on invested capital = -145%
This means that not only did I lose all the money I originally had to invest, but I'm now also in debt to the bank and unable to pay them. So even though my investment opportunity only lost 10%, I actually lost 145% of my own capital and now need to find $450 elsewhere to repay the bank.
This is the power of leverage, on the positive side it can be a great way to increase overall returns on your available capital. On the other hand it can cause great financial loss if not used carefully.