ISSUE #4: Leverage
This week we will be looking at the term “leverage”. Do enjoy!
The term “leverage” is derived from the Latin word “levere” meaning to raise something. The word as used in the English language today dates back to 1724 and was originally used to describe the action and power of a lever looking at the mechanical advantage it grants. According to the Macmilan Dictionary, the modern use of the term “leverage” in contemporary finance sense can be traced to the year 1933, which in itself coincides with a period in which there was a lot of activity in financial markets especially in the U.S.A.
In finance, leverage also known as gearing refers to the use of debt (borrowed funds) rather than equity in the purchase of an asset or in the financing of an investment. It is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. It refers to the relationship between debt and equity in a company.
If a company or an individual borrows money to buy assets, we say the company or individual is leveraging.
So, if you have one million naira to invest you can spend the whole amount buying one million naira worth of stocks, or you can buy two million naira worth of stocks by borrowing one million naira in addition to your one million. This is leveraging. It also puts you in a riskier situation. However, imagine you did not take out leverage and the value of the stock doubles to two million naira you have a profit of one million naira, but if you leveraged and you are lucky such that the value of the stock doubles to four million naira, you have a profit of two million naira after paying back the sum you borrowed and the amount you invested. Sweet, right?
Be warned, leverage increases risk! Just as leverage enables gains to be multiplied, losses are also multiplied especially where the leverage provided exceeds the income from the asset or investment, or the value of the asset or investment falls.
Imagine if you are unlucky and the value of the stock falls by 50%. Simply put, you have entered gbese(debt)! This, however, does not mean that the use of leverage is bad. It simply means that wisdom, common sense and a bit of good work in determining your luck and opportunities is profitable to direct.
In finance speak, there is the phrase “leveraged finance”. This refers to financing a company or business with more than normal debt (rather than equity or cash) proportions. It is funding a company or business with more debt than would be considered normal for that company or industry. Remember debt-equity ratio? Check Issue #2 of Finance “Yoga”.
Leveraged finance is often used to achieve a specific and usually temporary objective, such as; an acquisition of a company, to effect a management buy-out or management buy-in, to repurchase shares or fund a one-time dividend, for the purpose of recapitalisation in the case of paying an extraordinary dividend, or for investment in a self-sustaining cash generating asset. Usually, investment banks have leveraged finance departments where clients are helped to make leveraged loans for strategic decisions.
Usage in a Sentence
So now we can say for instance:
“The business is highly leveraged.”
“Leveraging the company at a time of tremendous growth opportunities would be a mistake.”
“I do not see the possibility of completing the project within time without the use of leveraged finance.”
“The Committee voted to limit tax refunds for companies involved in leveraged buyouts.”
I hope you have learned something new this week.
Please leave your comments below.
Remember, finance is not that hard!
See you next week!