What is Leverage?

When talking about leverage, there is always a word that is linked to it: DEBT. In fact, leverage is a measurement of how well a company/individual is using debt, aka the effectiveness of taking debts. It is an interesting (useful but risky) investment method to increase the potential return (or loss, of course) of an investment.

Leverage is always an interesting topic in finance, because of its duality:

• Pro: Taking a few amounts of debt is helpful because it helps increase the profit. Imagine that you have $100 now. If you invest these 100 dollars in the stock market, you could gain a return of 10%, which is $110 in total. However, there is another way to “leverage” your returns. With the $100 you have, you can borrow an additional $50 from the bank. Now, if you invest the $150 in the stock market, instead of $110, you now have a net asset of $165 (which is 55 dollars more, even if you pay the $50 dollars back, you still earn $5 more)! Imagine if instead of $100, you are leveraging millions of dollars... The difference will be gigantic.
• Con: According to the risk-return relationship, when an investment provides a higher return, one must be aware, because potentially, there might also be a higher risk. This is the same for leverage. By reading the benefits leveraging can provide, are you intrigued by this “magical strategy”? However, there is a cost. What if you borrowed $50 to invest in a stock, but instead, you had a -10% of return? Now, not only you cannot pay back the interest, but you also cannot pay back the original debt. If we magnify this scenario, instead of $50, you are borrowing $5 million. Now you know the real problem...

William Sharpe, the famous American Economist, the father of risk management (who developed the CAPM Model and Sharpe ratio) once said:

• “Some investments do have higher expected returns than others. Which ones? Well, by and large, they're the ones that will do the worst in bad times.” ——William Sharpe

Looking back into history, it is easy to discover that many severe financial crises are caused by debt and credit issues. This includes events such as the Great Depression and the 2008 Financial Crisis.

Therefore, we conclude that leverage is beneficial within a certain range. It turns risky when it exceeds the safety zone.

Leverage is also a crucial aspect to examine when analyzing a company. When measuring companies, there are some indicators that can help reveal the companies’ leverage:

• Current Ratio
• Quick Ratio
• Debt-to-Capital Ratio

These ratios measure the company’s leverage and liquidity (i.e., whether the company had enough current assets to pay back its debts). However, most of these ratios only work when compared with similar companies. Another problem is revealed: nowadays, it is obvious that different companies take different strategies. This might make the comparison method not as effective as imagined. Thus further research is often required to uncover the full story behind a company’s leverage strategy. The bottom line is, that financial analysis is all about “balance”. Methods and tutorials could only help investors approach closer to the balance point, but it also depends on how investors choose to find them. Different investors could come up with various investment opinions and strategies.