Leverage is a term that you will find in the business world, as well as in investing. This is something that can be incredibly useful for an ambitious business, but what are possible advantages and disadvantages that you need to know about?
Access to More Capital
The main reason for using leverage is to get access to more capital than would otherwise be the case. Leveraged finance is often used to give a company more financial clout. For example, when they want to buy-out a rival or make a purchase that costs more than they could afford from their own cash reserves. It can also be used to get through difficult times with reduced income, or while they under-take a major re-structuring operation.
This approach is sometimes called trading on equity, because the business is using borrowed money to try and increase the value of their assets. They may issue preferential shares or equity to access the funds that they need. The idea is that increasing the value of the assets will boost the company’s value by more than they could have achieved with their own money.
Firms in emerging industries, such as laser technology, could use it to quickly increase their assets. According to data from the Securities Industry and Financial Markets Association that was analysed by Forbes, the total debt owed by non-financial American firms was $9.6 trillion at the end of 2019. They confirmed that the most highly-leveraged firm was Colgate-Palmolive, with $72.50 of debt for every $1 they have.
In the case of the UK, we can find figures from 2018, published by Link Asset Services, that show the country’s corporate debt was sitting at over £390 billion. A large part of this borrowed money was paid out to shareholders as dividends. Another type of significant change came in the oil industry, where falling prices led to net debt rising more than 450% since 2009.
In investments, leverage is often used when trading foreign currency pairs. In the UK, forex brokers also offer different leverage policies, running from 1:3 to 1:5 in general. This shouldn’t be confused with the spread, which is also important in the forex world but that refers to the difference between the selling and buying prices of any currency pair.
Share traders may also use leverage as a way of looking to boost their profits. This is an efficient use of a professional trader’s capital. As long as they are aware of the risks, it lets them carry out bigger transactions very easily, as they just need to use their own cash to meet the minimum margin needed by the exchange.
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More Potential Rewards but More Risk Too
It is easy to see why companies use leverage. If they want to expand aggressively, this is one of the quickest and most effective ways of doing so. Even a firm that is relatively modest in size can make hugely ambitious moves when they take on debt in this way, such as buying out a rival that is bigger than them. It can also be important when revenue falls and their cash reserves aren’t enough to help re-structure or boost sales.
Therefore, leverage can help a company to progress more rapidly. It can also allow them to weather the bad times more easily. Yet, the down-side is that they are now more exposed to risk. If the investment doesn’t work out, they could be left with a large amount of debt but without the increase in their assets that they expected to see.
Clearly, a crucial point is the amount of interest to be paid back. This needs to be lower than the gains that they expect to achieve from their investment. The other side of the equation is that the investment needs to add enough value to cover the interest. So, both sides need to work well to make this a sound financial investment that justifies the risk it involves.
You should also bear in mind that using leverage increases the volatility level of any investment. If you borrow half of the money for an asset, any change in its value will have twice as big an effect as it normally would.
There is no doubt that leverage remains an important tool in the business world, as we can see by the fact that so many major firms use it. However, it is something that should only be used after carefully considering all of the other options and working out how the risks can be minimised.
