What Is Leverage, and How Can I Use It to My Advantage?

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Financial leverage is the choice to borrow money to invest in assets. The intent is to generate returns higher than the cost of borrowing these funds. If done strategically, carefully, and correctly, leverage can increase profitability without the need to add additional personal investment capital.

Investor use of leverage is intended to increase returns on investment. You can leverage your investments using various instruments, including options, futures, and margin accounts. Companies use leverage to finance the assets they own. The combination of selling stock and borrowing funds can be optimized to provide the best overall return to a given firm.

Financial leverage seeks to expand the potential returns from a project. But leverage can also multiply the downside risk potential if the business projections are not met. We speak of being “highly leveraged” when we refer to an unhealthy excess of debt over equity.

Let’s Look at a Couple Examples

1. Feckless Frisbee needs to expand its manufacturing capacity given that it’s running three shifts at 100 percent capacity utilization and experiencing shipping delays as order backlog keeps growing. Feckless Frisbee has $100,000 in cash, but chooses instead to borrow $100,000 for equipment that will double its production capacity from 1 million frisbees per month to 2 million.

If the monthly payments can easily be met, and the incremental profitability exceeds the interest on the loan, borrowing appears to be attractive. If, however, demand falls below 1 million frisbees per month, a result of new competition for example, the interest along with higher fixed costs on fewer units will result in worsening financial results and difficulty with cash flow.

2. Speculator Sam wants to buy Nvidia stock. At $120 per share, he has enough in his Robinhood trading account to buy 100 shares ($12,000). But if he uses his “margin account,” he can borrow another $12,000 and buy a total of 200 shares, doubling his potential upside on his investment. If he sells all his shares after the stock rises to $125, he will make $5 x 200 = $1,000 using margin. On the other hand, if the stock falls to $115, his loss is also twice as high. Worse, if the stock keeps falling and his margin account requires a certain ratio ($1 market to $1 of debt) between the market value and the loan amount, the brokerage may be forced to start selling shares, enough to bring the ratio back to what was agreed upon. Not good.

What Are Some of the Advantages of Using Leverage?

First, profits are increased using “other” sources of capital—that is, capital provided by a loan or selling bonds as examples, rather than internal capital that may or may not be available. Second, larger investments can be undertaken with borrowed funds. A simple example is if I want to buy 100 shares of Nvidia stock but have only $6,000, I can borrow the rest that I need on “margin.” Margin is the way to finance stock purchases with debt. At a company level, a big project may be too large to take on with existing capital. Additional capital needed can be obtained through borrowing or some form of debt. Finally, debt can provide opportunistic liquidity to quickly take advantage of new investments as they arise.

What Are Some of the Disadvantages of Using Leverage?

Just as investment returns can be expanded using leverage, losses can occur as well, as higher downside risk now exists beyond your initial capital investment before taking on debt. Collateral is pledged against debt, and if debt is not being serviced according to the agreement, assets can be repossessed. In addition, there are new costs that come with your new infusion of capital obtained using debt. Fees are common, but it is the interest that must be well covered by future and ongoing profitability to continue to service the debt until fully repaid.

For a stock trader opting to use margin leverage to increase the investment, if the stock price drops, the investor gets a “margin call.” That can mean you have to sell some of your stock at the reduced market price to maintain the agreed upon ratio of market value to debt in your trading account.

What Measurements Are Used in Calculating Leverage?

Business: Debt-to-Equity Ratio

A ratio higher than 1.0 means a company’s debt exceeds its equity. The higher the ratio, the greater the leverage risk. Another related ratio is times interest earned. If the interest on the debt can be paid several times over with profit remaining, the risk is lower even if the debt to equity is a high number.

Individual: Consumer Leverage Ratio

Consumer leverage = Total household debt ÷ disposable income

It is almost too easy to allow debt to ramp up to the point where servicing all of it is no longer possible. An individual may find they have debt in the form of several credit cards, a mortgage, an auto loan, and a student loan. When these become too difficult to manage from a budgetary standpoint, it may be time to consolidate some of this debt into one manageable monthly payment that is significantly less than the sum of the previous monthly debt payments.

Using leverage responsibly is crucial for long-term success. Traders should develop a disciplined trading plan and risk management strategy that includes considering all possible outcomes resulting from the use of leverage. Set realistic profit targets and put in stop-loss orders so you aren’t caught flat-footed in a stock price freefall and avoid overexposure to any single asset (concentration = risk).

At a business level, the debt service must always be updated and measured to compare to free cash flow to ensure debt service coverage is adequate with a cushion or margin of safety. For a long time, interest rates were low, but that has changed in the past two years because of inflation. That means excessive debt that must be rolled over or refinanced soon may also need to be reduced.

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