Fundamental Financial Concept: Leverage

Introduction to the concept of Financial Leverage

The contemporary business enterprises in a bid to enhance their profitability or the scope of their business often borrow capital or take out loans. However, they are often not sure regarding the manner in which the capital or the money that had been borrowed should be used by them to maximise the returns from the same. It is precisely here that the concept of financial leverage becomes important within the particular context of the modern-day business world.

The construct of leverage holds an important place within the framework of finances and is being extensively used by the different business enterprises to enhance the level of financial returns earned by them. However, for the effective usage of this construct the business enterprises need to take the help of different kinds of financial tools or instruments.  

What is the Fundamental Financial Concept of Leverage?

In simple terms, the construct of financial leverage refers to the process through which the business enterprises try to multiply their profit as well as losses through the effective usage of different kinds of financial tools or instruments. The primary gratification factor of the business enterprises behind the usage of this construct is to increase or enhance the level of potential return of investment so as to earn a higher amount of revenue or profitability and their improve their business prospects. More importantly, it had been seen that the business enterprises have the opportunity to take the help of different kinds of tools or instruments like borrowing capital or money, margin capital and others for the attainment of this end.

The construct of financial leverage is also an indicative of the amount of financial debts or for that matter the financial assets that a particular business enterprise boasts of. However, the primary idea is to maximise the returns on the cost of borrowing or the loans or debts taken by the enterprises. In this regard, it needs to be said that different business enterprises have been able to substantially enhance their business prospects of their business through the adequate usage of this process.

The benefits associated with the process of financial leverage notwithstanding there are certain risks involved with the usage of the same as well. For example, there is always the risk that the business enterprises might end up borrowing the amount of capital which is larger than the revenue generated by them or for that matter exceeds their ability to repay.   

What is the Definition of Leverage?

Different scholars or authors over the years have offered different definitions or interpretations of the concept of leverage. However, it is seen that within the world of finance the most commonly accepted definition of leverage is that it the process through the usage of which the business enterprises have the opportunity to maximise their return on different investments. In this regard, it needs to be said that this is an investment strategy which is being commonly used by the different business enterprises in conjunction with various financial tools or instruments to increase the financial returns that they derive from their diverse investments.

What are the types of leverage?

Broadly speaking, there are two major kinds or types of leverages commonly used by the different business enterprises, namely, operating and financial. The effective usage of the investment strategy of financial leverage requires the business enterprises to borrow capital either through the process of fixed-income securities (debts, loans and others) or directly from the different money lenders. The primary idea behind the usage of this process is to enhance the revenue generated by the enterprises by way of the enhancement of the scope of the business operations through increased investments.

The usage of the strategy of Operating leverage, on the other hand, requires the business enterprises to enhance returns and cash flows. This is usually done by way of increasing the fixed operational costs or the expenses of the business enterprises. The primary idea behind the usage of this strategy related to leverage is to enhance the efficiency of the operations of the business enterprises and thereby improve the financial returns earned by the enterprises.

How Leverage Works?

The process of financial leverage is rather simple and requires the business enterprises to take into account the revenue that they are generating on the basis of the investment that they have taken and the interest or the capital that they have to pay for the investment or debt. For example, the business enterprises need to calculate whether the total value or the revenue that they are generating is higher or lower than the interest or the capital that they have to pay for the investment. If the generated revenue is higher this means that it is a profitable investment and vice versa.   

What are the important Books On Leverage?

Some of the most important books on the concept of financial leverage that the students can consult are listed below-

1. Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives by Stephen J Antczak, Douglas J Lucas, Frank J Fabozzi
2. Leverage: How Cheap Money Will Destroy the World by Karl Denninger
3. Managing Derivative Risks: The Use and Abuse of Leverage by Lillian Chew
4. The Great Deleveraging: Economic Growth and Investing Strategies for the Future by Chip Dickson, Dr. Oded Shenkar
5. Leveraged to the Hilt?: Personal Finance with Professor Bill by Bill Keating

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Bibliography

1. “What is Leverage?”. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/leverage/
2. “Best Selling Financial leverage Books”. Retrieved from https://www.alibris.com/search/books/subject/Financial-leverage
3. “What is financial leverage?”. Retrieved from https://www.accountingcoach.com/blog/what-is-financial-leverage
4. “Financial Leverage”. Retrieved from https://efinancemanagement.com/financial-leverage
5. “Degree of Financial Leverage – DFL Definition”. Retrieved from https://www.investopedia.com/terms/d/dfl.asp