What is financial leverage?

Key takeaways: Leverage is the use of borrowed money to boost the size of an investment. It can amplify returns but also risks magnifying losses if the investment performs poorly.

Financial leverage is the use of borrowed money to increase the size of an investment.

Investors, companies, and private equity firms all use leverage to amplify potential returns while committing less of their own capital upfront.

However, leverage is a double-edged sword. While it can increase profits when investments perform well, it can also magnify losses if asset values decline.

Whether you're buying a home with a mortgage, analyzing a company's balance sheet, or studying leveraged buyouts, understanding how leverage works is one of the most important concepts in finance.

What is leverage? How do investors use it?

At its simplest, leverage means using borrowed money (debt) to invest so you can potentially earn a larger return than you could with your own money alone (equity).

Imagine two investors each want exposure to an asset that rises in value by 10%.

Both investments increased by the same 10%, but the investor using leverage earned a much larger return on their original $100 investment.

This illustrates why leverage can be such a powerful financial tool.

However, while it can increase profits, it also increases the risk of bigger losses. Without leverage, a $100 investment falls to $80, producing a $20 loss. With leverage, however, the $500 total investment falls to $400. After repaying the $400 loan, the investor's entire $100 equity investment has been wiped out.

In practice, leverage also creates additional obligations because interest payments must be made regardless of how well an investment performs.

Furthermore, if cash flows deteriorate or borrowing costs rise, highly leveraged businesses may face financial distress much sooner than companies with little debt.

How do companies use leverage?

Many corporate investments are also financed using a combination of equity and debt.

Companies frequently borrow money to finance acquisitions, build factories, invest in research and development, repurchase shares, or refinance existing debt. Investors therefore pay close attention to how much leverage a company uses.

Because leverage reflects the relationship between debt and equity, investors often measure it using financial ratios rather than simply looking at the amount of debt a company has borrowed.

One of the most widely followed is the Debt Ratio, which reveals how much debt the company uses to generate its assets. A ratio of 1.0 indicates the company has $1 of debt for every $1 of assets. If the company has more assets than debt, then the ratio drops below 1.0, and if the company has more debt than assets, then the ratio rises above 1.0.

Another important metric is the Debt-to-EBITDA ratio, which compares a company’s total debt with its annual earnings before interest, taxes, depreciation, and amortization (EBTIDA). This indicates how much income is available to pay down debt before operating expenses are deducted from income. Higher ratios mean it may take longer for the company to repay its borrowings.

Investors also frequently use the Debt-to-Equity ratio, which compares what the company has borrowed from lenders to what it has raised from private investors or shareholders. A ratio over 1.0 indicates a company has more debt than equity, but this may or may not be a problem depending on the company’s overall profile.

Lastly, some analysts, including The Shareholder Daily, smooth out short-term fluctuations by calculating the Average Financial Leverage Ratio over multiple reporting periods rather than relying on a single balance sheet.

One way to do this is to calculate the average total assets and average shareholders' equity over the previous 12 months, then divide average assets by average shareholders' equity. This produces an average leverage ratio that can provide a more representative picture of how much leverage a company has employed throughout the year, particularly for businesses where assets or equity fluctuate significantly between reporting dates.

These ratios help investors assess how reliant a business is on borrowed money and how easily it may be able to service its obligations.

However, it’s worth noting that no single level of leverage is appropriate for every business, and there are wide variations in what can be considered healthy. For this reason, leverage ratios are most useful when compared against a company's historical results and industry peers rather than viewed in isolation.

Leverage in private equity

Leverage is one of the defining features of modern private equity investing.

In a leveraged buyout (LBO), a private equity firm acquires a company using a combination of investor capital and borrowed money. For example, a private equity firm might purchase a company for $10 billion using $3 billion of equity and $7 billion of debt.

Over time, the acquired company's cash flows are often used to repay that debt. As debt declines, a greater proportion of the company's value belongs to the equity investors.

If the business also improves operationally and increases in value, the combination of operational improvements and debt repayment can significantly increase returns for shareholders.

This is one of the primary reasons leverage has become such an important tool within private equity.

Leverage in everyday life

Leverage is not limited to professional investors or large corporations. In fact, many people use leverage in their everyday lives, often without thinking of it in those terms.

The most common example is a mortgage. Rather than paying the full purchase price of a home upfront, buyers typically contribute a deposit and borrow the remainder from a bank. This allows them to purchase a much more valuable asset than they could afford using only their own savings.

If the property's value rises, the homeowner benefits from the appreciation despite only contributing a fraction of the purchase price themselves. Conversely, if property prices fall significantly, the homeowner's equity can decline much more rapidly because of the leverage involved.

Key takeaways

Financial leverage allows investors and companies to control larger investments by using borrowed money alongside their own capital.

While this can significantly amplify returns when investments perform well, it also increases losses and financial risk when they do not.

For investors, understanding how leverage is measured and how it is used across businesses, private equity, and everyday finance is essential for assessing both the potential rewards and the risks of any investment.