Leverage
Explanation: Leverage refers to the use of borrowed funds to increase the potential return on investment. It involves using various financial instruments or borrowed capital to increase an investment’s potential return. Leverage can amplify both gains and losses, making it a high-risk, high-reward strategy. Companies and investors use leverage to invest in assets or projects they couldn’t afford otherwise.
Example: A company with $1 million in equity borrows an additional $2 million to invest in new projects. This leverage means the company is using $3 million to grow its business, potentially increasing returns. However, if the investments don’t perform well, the company still has to repay the $2 million loan, increasing its financial risk.
Reference Link: For more information on leverage, visit Investopedia’s Leverage.
FAQs:
- What are the risks of using leverage?
- Leverage can amplify losses as well as gains, leading to increased risk of financial distress or bankruptcy.
- How is leverage measured?
- Common measures include the debt-to-equity ratio and the leverage ratio, which assess the level of debt relative to equity or assets.
- What are the benefits of leverage?
- It can enhance returns on investment, enable significant investments, and optimize the capital structure.
- Can individuals use leverage?
- Yes, individuals use leverage through mortgages, margin trading in stock markets, and other forms of borrowing to invest.
- What is financial leverage?
- Financial leverage specifically refers to the use of debt to finance the acquisition of assets, with the goal of increasing the return on equity.